For most of 2002, the LBO community seemed like the collective boy who cried wolf. Every time the market dipped or someone spoke ill of private equity, a buyout pro would counteract with promises that LBO activity was about to explode. Indeed, the conditions seemed ripe enough, with valuations low and buyout funds sitting on mountains of cash. But during the first half of the year, the spike in activity failed to materialize.
Then, during the dog days of summer, of all times, the wolf finally showed up.
In the third quarter, 54 deals closed for a combined total of $10.8 billion, more than double the volume in the previous quarter and 58% higher than the year-ago period, when there were 44 deals totaling $3.95 billion.
Combined with the previous two quarters, 2002 has now seen about $20 billion. But that’s hardly representative of market activity. In fact, the year should finish with significantly more volume than 2001, as multibillion-dollar transactions for Burger King, QwestDex and Bell Canada Enterprises could close this year and several more deals are being worked on right now.
“Putting aside macroeconomic issues, deal flow should remain strong in 2002 and into 2003,” says Stewart Kohl, managing general partner for The Riverside Company, which closed two deals last quarter.
All this activity comes in spite of the still-tricky lending environment, which has been hampered by banking consolidation, an increase in problem loans and the sluggish economy. In many cases, buyout firms are making the always-uncomfortable decision to contribute more equity. According to Portfolio Management Data, the average equity ratio on LBOs was 40.9%, which is the highest level in recent memory.
To be sure, increased equity investments are much easier to do when you’re flush with cash. According to the latest estimate from Thomson Venture Economics, publisher of Buyouts, buyout firms have $110 billion of uninvested capital to put to work. But while cash may not be a problem for most buyout firms, the real challenge is earning a return after putting in more equity than they’d like to. As of March 31, 2002, buyout funds had an average one-year return of 10.7% and a three-year return of 0.6%, according to Venture Economics, and with the exit market practically nonexistent, it will take time to reverse that trend.
Break Me Off A Piece
A number of buyout firms took advantage of the prevailing weakness in the economy by targeting distressed companies and corporations looking to divest parts of their business. The corporate carve-out was a recurring theme last quarter, with large corporations like Qwest Communications, International Paper, Vivendi Environnement, Lucent Communications, Georgia Pacific and International Multifoods among the numerous parties deciding to sell units to private equity firms.
Riverside’s Kohl says corporate divestitures thrive in this kind of economic environment. As corporations adjust their strategy to focus on their core operations, they aren’t as likely to wait out a weak market in their search for buyers, essentially taking what the market will give. That certainly isn’t the case with all sellers, as some remain hesitant to market themselves at what they feel are reduced values. However, “with the passage of time,” Kohl says, “sellers will begin to accept the new valuations, which will open the door for more deals.”
Telecom companies, in particular, have had to sell off some of their businesses in order to make debt payments or boost capital, their plight exacerbated by the weakening economy and increased competition from other phone operators and wireless companies.
Last quarter’s largest announced deal came in July, when a consortium comprised of Carlyle Group and Welsh, Anderson & Stowe agreed to acquire Qwest Communications’ QwestDex telephone directories business for $7.04 billion. A month later, Kohlberg Kravis & Roberts rang in with its own yellow-pages acquisition, crossing over the northern border to buy Bell Canada’s directories unit for the equivalent of $1.8 billion. Meanwhile, Sprint’s SPA directory business drew interest from a number of buyout firms before yellow-pages marketer R.H. Donnelley finally stepped in to acquire the business (see story on page 1).
Speculation into to whether there will be more directories sell-offs is mixed. Benjamin Coughlin, a principal with Spectrum Equity Investors conjectures, “Assuming the telco doesn’t have financial constraints, I doubt you’ll see many more outright sales to private financial firms.” He adds, “For now I expect to keep seeing larger guys picking up the smaller independent directories, but in the next couple of years you may see other media organizations like newspapers and outdoor advertising firms begin to look at the market.”
Another opportunity for LBO shops lies in the Sarbanes-Oxley Act, which became official this past July. Several players in the LBO market say it will encourage middle-market companies to go private. With this in mind, Kohl maintains “private equity could eventually become the public market’ for middle-market companies seeking capital and liquidity.” (Read more about this on page 26)
While it attracted the most headlines, telecom certainly wasn’t the only sector to offer buyout opportunities. Following through on a trend that started in the second quarter, a number of LBO firms filled up on food-related deals. Vestar Capital Partners’ $835 million acquisition of Agrilink, Clayton, Dubilier & Rice’s $967 million purchase of Brake Bros. and Wellspring’s $180 million deal for Multifoods Distribution were among the more notable food deals last quarter. Restaurants were also popular, with Texas Pacific Group, GS Capital Partners and Bain Capital teaming up for the $2.26 billion acquisition of Burger King (not closed yet) and Castle Harlan winning its bid for the Morton’s Restaurant Group. All told, the food-related category attracted approximately $4.3 billion of deal flow, or more than a quarter of the total volume in Q3.
CD&R Principal David Novak said after the technology and telecom collapse, private equity firms are looking for some stability in their portfolio. “The [foods] sector is very stable. People have to eat,” he says, adding that since the industry relies on smaller transactions-often one customer at a time-companies in this space generally don’t rely on a single contract that can make or break a business.
Meanwhile, Kohl indicates that healthcare companies are attractive as well, noting that the industry is less exposed to the economy because of the aging baby-boomer population, which sustains demand in this industry. He also lists packaging, automotive, home furnishings and building companies as some of the more popular industries these days. Still, Kohl remains cautious when it comes to the building and home furnishing names, noting that the housing cycle generally lags behind the economy, and industries that depend on new home starts could be facing a pitfall.
The Audax Group’s Jay Jester, who is primarily responsible for developing deal flow at the firm, also sees potential in certain areas of the technology sector, telling Buyouts, “There’s still plenty of productivity to be squeezed out of technology.” Additionally, he adds that energy concerns could also draw some interest. At the end of the day, though, what LBO firms focus on is still largely driven by what industries the banks will agree to lend to, he says.
Jester also notes that energy concerns could draw some interest, but he maintains that much of what can be targeted by the LBO firms is actually driven by what the lenders will agree to take on.
Another trend evident in the third quarter is that increasingly U.S. firms are hunting for deals overseas. Novak identifies Europe, specifically, as drawing the most interest from U.S. firms. He adds, though, that Asia and Latin America as alternatives are not all that attractive for U.S. buyout funds right now, as investors in Asian companies need to contend with vastly different property rights and legal structures, while Latin America has always proved difficult to target returns.
That said, there does appear to be some real upside in Asia, where the traditional conglomerate-heavy market is starting to change. Evidence of this can be seen in Seoul-based Kumho’s decision to divest its tire unit. In February, the conglomerate agreed to a $1.2 billion offer from JP Morgan Partners and The Carlyle Group for an 80% stake of Kumho Industrial Co., which is the second largest tire maker in Korea. While the deal has not yet closed, it could represent a blossoming opportunity in Asia’s private equity market.
Looking ahead, the consensus points to sustained growth in LBO activity going forward. However, Kohl cites the possibility of a war with Iraq, a potential double dip in the economy and further declines in the stock market as “worry cards” going into the next year.
Moreover, there are real problems that are already impacting deal flow, most notably the difficulty in obtaining debt financing for cash-flow based leveraged buyouts. Second, most LBO shops are still waiting for an increase in the number of quality companies that go up for sale. Generally, the more attractive targets are still trying to wait out the storm in anticipation that their valuations may rebound. And third, with the dearth of quality businesses on the selling block, the inherent competition for the preferred companies sends prices higher. In turn, this means that firms now have to direct their focus on improving a business’ operations in order to get their anticipated return, thus removing some of their attention away from the procurement of further acquisitions. Jester notes that the increased competition has even led a number of firms to shave their IRR models to the low 20% levels.
However, Jester indicates that in the coming years, the changing demographics will help to foster continued growth in buyout-related deals, both in terms of total numbers and monetary volume. He illustrates that the baby boomers and the generation preceding the baby boomers will be looking to sell or recapitalize their businesses as they approach retirement. Jester concludes that while there should be no shortage of deals, one of the biggest challenges will be how firms manage to sift through all of the potential targets, noting, “You’ve got to kiss a lot of frogs to have a shot at the best ones.”