Leverage Drought Sends Deal Volume Lower

“It’s like we’re playing Twister in the dark here,” said one general partner, trying to describe rapidly deteriorating market conditions.

As of press time, U.S. firms had consummated a total of 636 control-stake deals through the end of the third quarter, a 24.0 percent drop compared to the 837 buyouts closed over the same period in 2007, according to data from Thomson Reuters, publisher of Buyouts. During the third quarter, U.S. firms closed 196 control-stake deals, an 8.4 percent quarter-over-quarter decrease from the 214 deals closed in Q2 2008, and a 22.2 percent drop compared to the 252 completed deals made in Q3 2007.

The third quarter saw no evidence of a return of the mega-deals that thrived before the credit crunch began last summer. Only nine deals broke the $1 billion barrier in the past three months. All told, the 49 deals last quarter with disclosed values totaled about $52.3 billion, a sharp increase from the $11.2 billion that closed in Q2 2008, but it’s a figure that comes with a major caveat. A single deal, the $25.9 billion take-private of Clear Channel Communications Inc. by Bain Capital and Thomas H. Lee, accounted for more than half of the disclosed deal value for the quarter. Conceived in Nov. 2006, the 11-figure deal represents a relic of a bygone era.

Avista Capital and Nordic Capital closed the third quarter’s second-largest deal with the $4.1 billion LBO of health care product maker ConvaTec from Bristol-Myers Squibb Co. (NYSE:BMY). Next up was the $3.1 billion buyout of German building materials concern Xella International, acquired by GS Capital Partners and PAI Partners, followed by The Carlyle Group’s $2.5 billion carve-out of Booz-Allen Hamilton’s government contracting business. In all three cases, the sponsors used equity to pick up 50 percent (49 percent in Carlyle Group’s case) of the total takeout price, according to Reuters Loan Pricing Corp.

High-tech, industrials, and consumer products & services—in that order—proved the most popular sectors of the quarter, accounting for 97 deals, or 49.5 percent, of the total (see chart on page TK for more details). That’s relatively consistent with Q2 2008, when the same three industries topped the charts, albeit in a different order, accounting for 104 deals, or 48.4 percent of the total.

In terms of deal activity, middle-market firms, still able to obtain adequate financing compared to their mega-market brethren, took the lead for the most part over the past three months. The perennially busy Riverside Co. led the charge with eight closed deals in the quarter, followed by Carlyle Group (admittedly not a mid-market firm) with seven deals and Advent International, Audax Group and Marwit Capital, each with six closed acquisitions between the beginning of July and the end of September.

While deals are getting done, seller’s expectations, thus far, remain higher than the market’s reality. This is expressed as a disconnect, or widening chasm, between purchase price figures and the amount of leverage actually being used to support today’s buyout deals.

The average purchase price multiple for U.S. buyouts has dropped little more than half a turn from 2007’s record-breaking average of 9.7x EBITDA, to 1H 2008’s 9.0x, according to Standard & Poor’s. Meanwhile, total leverage dropped more than a full turn of EBITDA from 2007’s average of 6.2x EBITDA to 1H 2008’s 5.1x EBITDA.

As such, buyout firms this year have been deploying more equity on a per-deal average than they have at any time in the past decade. When considering the LBO market as a whole, general partners in the first half of 2008 wrote equity checks to cover an average of 39.3 percent of their total deal cost, representing a mean multiple of 3.7x EBITDA. By contrast, the average equity contribution in 2007 covered only 30.9 percent of the total deal, translating to an average multiple 3.5x EBITDA, according to S&P.

Piling On

With debt scarce and expensive, more buyout firms are taking a step back from making new portfolio acquisitions to instead focus on shoring up their existing portfolio companies with add-on acquisitions.

Of the 636 deals completed this year, 248, or 39 percent, have been add-on acquisitions, compared to 2007’s 365 add-ons, which accounted for 35 percent of that full-year’s deal flow. While a four percentage point increase may seem insignificant when considering the market as a whole, it is noteworthy that a number of firms appear to either be out of the platform acquisition business altogether, or have at least stepped back.

All six of the deals closed by Boston-based Audax Group this past quarter were add-on deals, while Golden Gate Capital, HM Capital, and Silver Lake each closed two deals a piece in the past three months—all add-ons.

Fenway Partners says it is spending more time making add-ons than sourcing new platform deals. The New York firm, which invests in companies with enterprise values up to $600 million, has completed several add-ons this year, including two in the third quarter for trucking company RoadLink USA. For Fenway Partners the add-on has become a strategic method to de-lever its existing portfolio companies. The strategy is to acquire add-ons with up to 100 percent equity both from its own funds and equity partners rather than having their platform companies issue new debt in a thorny market. The cash flow from the now-larger portfolio company then goes to pay down its debt on an accelerated basis. “It’s easier to work with something we’ve known and understood for the past five years than to try and take on something completely new in an uncertain market,” said Fenway Partners Managing Director Tim Mayhew.

Boston-based Parthenon Capital is another firm that’s spending a lot of time hunting for add-ons. “Certainly making new platform investments is more challenging at this time,” said Bill Winterer, a managing partner at Parthenon Capital. “You have to find the right company with the right visibility and outlook, then you have to be able to raise financing around it and come to a price agreement with the seller. It’s definitely a more difficult deal environment than it was a couple years ago.”

At the same time, turmoil in the credit markets is providing Parthenon Capital with add-on opportunities. A number of companies, unable to finance their expansions, are looking to private equity for growth capital. In addition, the prospect of a jump in the capital gains tax from its current 15 percent has some small business owners looking for liquidity sooner rather than later, Winterer said. So far this year, Parthenon Capital, which invests in financial services and health care out of a $700 million Fund III, has closed add-on acquisitions for insurance companies American Wholesale Insurance Group and Assention Insurance, as well as for health care companies Abeo Inc. and Intermedicx.

Conspicuously absent from the third-quarter deal charts were a number of dedicated turnaround shops, including Cerberus Capital, KPS Capital Partners, Littlejohn & Co. and MatlinPatterson. A number of turnaround pros told Buyouts in July that they were still waiting for the market to bottom out—or for the proverbial “knife” to stop falling—before they put their money to work in today’s troubled companies.

Conspicuously bucking the trend was Monomoy Capital, which closed three deals in the third quarter and plans to continue its investment pace to the point that it may have to consider raising a new fund later this year to replace its $280 million first fund, which closed in Jan. 2007. Partner Stephen Presser said the number of potential investment opportunities coming the firm’s way every month has doubled over the last quarter. Many are high-quality businesses that simply over-levered or are looking to be divested by larger corporate parents angling for some extra cash, Presser noted.

“In the mid-market restructuring space—unfortunately or fortunately—we have too much deal flow,” Presser said. “We really have emergency room-like triage in our deal flow group here to understand…where we should be deploying our capital.”