The year 2005 came in with a bang. It left with a deafening explosion. Last year was a record-breaker in every way for the private equity market, with a staggering $198 billion of private equity-backed buyouts and more than $173 billion raised by buyout and mezzanine firms. The deal total represents a 44% jump over 2004 totals, while fund raising numbers exceeded last year by $131 billion. While the deal statistics were clearly helped by King Kong-sized acquisitions like Sungard, Hertz and Toys “R” Us (See Deal Wrap Up Story Page 51), the middle and small markets played an equally important role in 2005’s frenzy of deal activity as more than 325 hundred acquisitions were under $500 million.
“2005 was an incredible year in that we saw unprecedented activity and high valuations. It was a confluence of a lot of factors, including good financing. We’re in our third year of economic recovery and there was a pent-up supply of properties that private equity firms couldn’t bring to market before,” says Eric Bacon, a senior managing director with Linsalata Capital, which raised a $425 million fund in 2005.
But while seemingly every firm was looking for deals, winning them in 2005 was an entirely different matter. General partners sitting on so much capital, combined with relatively free access to financing from a variety of sources-including hedge funds-the bidding process was fast and furious, and in a few cases deal multiples even soared to double-digits. Firms who really wanted a company were often forced to pay a lot more than they anticipated. Why did they pull the trigger? In many cases, it had to do with the need to deploy capital.
“We bought and we paid too much in some cases,” said Linsalata’s Bacon. “There’s pressure to invest the capital you took responsibility for. We closed our fund in June and we usually do about four deals a year; instead we did two. In some sense we are not willing to pay those multiples.”
Others refused to pay up, and were thus forced to remain on the sidelines altogether. “Valuations were so high and competitive last year. There were so many [bidders] that we were off by 20% several times. We were thinking we were there with a 7.5x multiple, and then the company went for a 9x multiple,” said one general partner.
Looking Ahead
Looking ahead, the big unknown for 2006 is not whether deal activity will continue-most private equity pros we spoke to believe it will for the next six to 18 months-but whether the 7x-plus average debt multiples averaged in 2005 will drop at all. Some are projecting multiple shrinkage to the 5x-6x level. “In 2006, the market will be a little bit more reasonable, maybe gravitate back a little,” says Bacon. “Banks may be a little more discriminating because they might be starting to worry about being overleveraged.”
Some GPs are hoping banks stop lending so aggressively. “Competition is still fierce, primarily because the financing markets are incredibly strong and banks continue to put together fairly aggressive financing proposals,” one buyout pro told Buyouts. “Frankly, I wish the financing markets would get a little softer to maybe drive down some of the valuations a little. But it’s a double-edged sword in that, if you’re selling properties, the higher valuations work in your favor.”
But even if senior lenders become more stingy, general partners have a variety of financing options at their disposal. Hedge funds, in particular, were aggressive lenders for LBO deals, and in many cases did not require the same level of due diligence as traditional lenders. “There’s just so much capital and debt capital out there. Even if the banks pulled back, how much would it matter?” says Mark Jones, a managing director with River Associates, a private equity firm focused on the small market. “With firms like Capital Source, Madison Capital and all the hedge funds lending, I am not sure that if traditional banks pulled back a little bit it would change things all that much.”
Another GP argued that 2005 was the perfect time to raise a fund, and 2006 is the year to start investing. “We raised a fund because it was the right time and we are looking at deals, but we haven’t invested because we are waiting out the competition a little bit,” says another pro at a middle market private equity firm. “We think 2006 might be a better year to invest.”
Based on the pipelines the investment banks are seeing, there are still plenty of investment opportunities. “We expect 2006 to continue the rapid pace from 2005 and be a busy year for all of us. While there are certainly risks that could disrupt the macroeconomic environment, including natural disasters, terrorist activity, a devalued U.S. dollar, increased commodity pricing and residual uncertainty in Iraq, we believe the core drivers of the M&A market are intact and provide a strong base for continuing momentum into 2006,” said Jeff Rosencranz, a managing director and co-head of Piper Jaffray’s M&A division. “Private equity firms are expected to continue to be active sellers, especially as more cyclical companies with improved financial performances and investments that have been held longer than anticipated. More capital will almost certainly be put to work.”
This year is already off to a strong start as Apax Partners, KKR, Providence Equity Partners, Permira Advisors and The Blackstone Group expect to close their $15.3 billion acquisition of Denmark’s largest phone company, TDC AS, sometime this month. If completed, that deal will become the second-largest private equity transaction of all time, dethroning the $15 billion Hertz deal after less than two months.
Another mega deal that reportedly is nearing a close is the $8 billion taking-private of Affiliated Computer Services Inc. by a consortium including Texas Pacific Group, Bain Capital and The Blackstone Group.
Year to date, private equity firms have a disclosed $100 billion worth of deals lined up in more than 110 separate transactions that are expected to close sometime this year. So for now it appears as though the market will stay about as active as it’s been.
“I’m not sure there is a whole lot of room to go up,” says Joseph Nolan, a principal at GTCR Golder Rauner. “It’s more a question of how long can we maintain these leverage levels? Nobody can say for sure, but leverage is still available and I don’t see any clouds on the horizon in ’06.”
GPs echo that sentiment. “An unforeseen external event can slow this down, but everything looks pretty good. People with valuation discipline have sat back a little bit, but there doesn’t look like there’s going to be any slowdown in deals in 2006. The market will continue to be pretty aggressive,” says Jones. “For the people that don’t want to buy, it’s a great time to sell. Investors want you to do both. It’s a good news, bad news scenario.”
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