With valuations still affordable and buyout firms armed with plenty of cash, there’s plenty reason for enthusiasm in the LBO market. But bring up the issue of financing, and even the most ebullient buyout pro quickly turns morose.
As of early November, debt multiples were hovering around 2.7 times EBITDA, a historically low number and almost an entire point lower than 3.6 times average lending multiple of 1997. Market pros point to the shrinking pool of senior lenders-much of it caused by bank consolidation-a struggling economy over the last 18 months and the lowered appetite for risk following the telecom and technology downturns.
“A number of telecom loans, [in] both debt and high yield, have left the lenders licking their wounds,” says John Danhakl, a partner at Leonard Green & Partners.
Faced with a stingy lending market, buyout firms are thus in the position of either waiting for multiples to improve before they invest or making the uncomfortable decision to contribute more equity in order to do deals now. Many are doing the latter: The average equity contribution to leveraged buyouts reached 40.9% in the third quarter, nearly doubling the 20% average from a decade ago, and more than 10 percentage points higher than five years ago, when the equity portion averaged 30 percent, according to Standard & Poor’s Leveraged Commentary and Data.
Meanwhile, the banks that still lend to LBO firms are reevaluating their strategies as well, farming out more of the risk to institutional investors through the syndication process. Standard & Poor’s LCD reports that institutions accounted for roughly 80% of the leveraged buyout loans in the third quarter, while banks chipped in with around 20%. These figures are in sharp contrast to those of less than two years ago, when, in the first quarter of 2001, institutions provided under 40% of the loans and banks accounted for more than 60%.
There has also been a more pronounced drop in the debt multiple for firms investing in New Economy companies, namely tech and telecom, as the lenders are looking for more downside asset protection in their flight to quality.
Changing Course
So, how are buyout firms adjusting to this anemic lending environment?
For one, many of them are limiting their search to asset-based deals, which they know are easier to get financed nowadays. Indeed, in transactions that involve a concentration of assets and have a lower cash-flow margin, buyout shops have turned to asset-backed loans and overadvance, or senior-stretch, financing. These options provide the benefit of a highly leveraged deal but also allow for a favorable amount of flexibility and a forgiving structure. “We’re seeing more asset-based deals and there’s also more competition for those deals,” says Bob Stefanowski, managing director of GE Merchant Banking, adding that some banks have exited the cash-flow arena entirely.
Nobody said buyout firms can’t adapt, and as the industry has clearly shown, it will always find a way. Firms today are looking to institutions to fill in the void. Standard & Poor’s LCD reports that institutions accounted for roughly 80% of the leveraged buyout loans in the third quarter, while banks chipped in with around 20%. These figures are in sharp contrast to those of less than two years ago, when, in the first quarter of 2001, institutions provided under 40% of the loans and banks accounted for more than 60%.
To compensate for this, LBO lenders are distributing their loans more broadly across the market, syndicating smaller portions to a greater number firms in order to spread their risk. There has also been a more pronounced drop in the debt multiple for firms investing in the new economy companies, namely tech and telecom, as the lenders are looking for more downside asset protection in their flight to quality.
In deals that involve a concentration of assets and have a lower cash-flow margin, buyout shops have turned to asset-backed loans and overadvance, or senior-stretch, financing. These options provide the benefit of a highly leveraged deal but also allow for a favorable amount of flexibility and a forgiving structure. Managing Director of GE Merchant Banking Bob Stefanowski supports this, noting, “We’re seeing more asset-based deals and there’s also more competition for those deals.” He adds that some banks have exited the cash-flow arena entirely, making the asset-based loans the primary option in finding leverage.
That doesn’t mean cash-flow deals have gone the way of the dinosaur, though. “The leverage multiples are down, but the opportunities for the larger cash-flow deals are still around,” says Ira Kreft, a senior vice president at Fleet Capital Corp. He cites the recent Berry Plastics acquisition by GS Capital Partners and JPMorgan Partners as an example of this and notes that for strong companies with EBITDA north of $50 million, there is still financing for cash-flow based deals.
Many firms are also relying on the leverage-buildup scenario, enabling buyout shops to gradually amplify their debt in a platform company through buying add-on acquisitions. Lenders are typically more comfortable with financing an add-on deal, as the acquisition itself predicates growth. This generally allows firms to secure a better debt-to-equity ratio for the add-on, which, when combined with the platform company, improves the ratio for the entire investment.
John Lutsi, general partner at Morgenthaler, cites this strategy as central to his firm’s approach in boosting leverage. He notes that because of the instant improvement in EBITDA and the elimination of competitors that is inherent to add-on deals, it is also easier to procure cash-flow based financing. “A deal that starts out with a 60/40 debt-to-equity ratio, can quickly become a 75/25 ratio,” he notes.
Lutsi points to Morgenthaler’s acquisition of United Tri-Tech as an example of this strategy, detailing that while the original deal started with just a 50/50 debt-to-equity ratio, when the company acquired a Nortel Networks’ unit in February of this year, Morgenthaler was able to jack up the financing to a 62/38 ratio. However, Lutsi points out, “Time works against you. You need to start adding acquisitions within three to five years in order to make a significant difference on the IRR.”
Lutsi also identified that teaming up with publicly traded companies for acquisitions will generally allow the buyout shop to take on the bulk or all of the debt in a given transaction. The two parties maintain separate balance, allowing the public company to limit the amount of debt, to the relief of its shareholders, while the private firm is able attain the leverage it desires.
No matter what deal type, buyout firms are increasingly looking to mezzanine financing to fill in the gap between equity and the senior debt portion. Unlike the senior lending community, the mezzanine market has expanded over the last few years, with the latest informal tally counting more than 110 different firms.
However, Stefanowski stressed that mezzanine financing isn’t cheap. Typically mezzanine investors will target an 18% to 20% IRR. To get these returns, mezzanine debt is generally issued with an interest rate of around 12% to 12.5% and a maturity ranging from five to seven years, although Clarence Schwab of Golub Associates notes that the rate depends on the size of the firm being financed. Mezzanine deals also usually include an equity kicker, or warrants to buy common stock, to fill in the rest of the 18% to 20% anticipated return. The warrants are valued based on the company’s expected future performance, or incremental interest, and are compensated on a PIK basis. Additionally, there is often a fee for each mezzanine transaction that can range from two to three percent.
Meanwhile, the contribution of high-yield debt to loan structures got a nod of encouragement recently with the placement of $975 million in high-yield bonds to facilitate The Carlyle Group’s and Welsh, Carson Anderson & Stowe’s $7.04 billion buyout of Qwest’s directories business. However, while this was a heartening sign, many in the industry don’t believe it represents a return to the old days. The high-yield market is still feeling some pressure, as evidenced by a 3.02% drop in the Merrill Lynch High Yield Master II Index in the third quarter. Additionally, prior to the pricing, the buying consortium and its banking group had to cut back the bond sale by $75 million and put in a corresponding amount of equity, in effect, trimming the leverage of the deal. Moreover, buyout pros emphasize that only the large high yield transactions-north of $150 million-provide enough liquidity for most junk investors to care.
The QwestDex acquisition is also an example of how a number of firms are working with other buyout shops to put together club deals, in part to decrease their own equity contribution. Recently, buyout firms have combined forces to put together deals for Burger King and Houghton Mifflin, in addition to QwestDex, and also submit bids for TRW. Club deals are not always an attractive alternative to some in the industry, though, as they generally add a tier of complexity and can slow down a transaction, with the firms wrangling for control of the deal.
It’s clear that buyout firms have adapted to the current lending environment, but many still miss the high-leverage, high-return days of yore. However, there are those in the buyouts industry that still don’t see the financing quandary as such. Mark Williamson, a managing director at Fremont Partners, maintains, “Our firm is more focused on unleveraged rates of return.”
“We would rather pay 5 to 6 times EBITDA with 3 times leverage than be able to borrow at 6 times, but have to pay 8 times to 9 times EBITDA for an acquisition,” he says, adding that while the lending markets are selective there is still plenty of available financing for the quality deals. “The environment makes it harder to get the mediocre deals done, but that should be a good thing for everybody.”
With financing the way it is, that may be the most realistic approach, especially since there’s not much visibility as to when the lending backdrop may improve. “It’s going to be slow,” Kreft says. “We need a visibility and predictability of earnings. There needs to be stability for more than a quarter before things return to normal.” He goes on to compare the current drag to that of the early 1990s, but notes that it’s still “difficult to say if the results will be the same.”
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