Parting of Ways Over Price?

The shifting debt market that’s sending tremors through the buyout business is also shaking up the heady expectations of the last five years for both buyers and sellers.

Tougher lending terms—marked by higher interest rates and generally more expensive debt—means financial sponsors are less likely to generate the gaudy returns that have so far defined this cycle. At the same time, sellers that routinely counted on valuations of 7x or 8x EBITDA will have to consider those kinds of deals to be outmoded extravagances. In the last month, leverage multiples have come down by a half turn to a full turn on mid-market deals, several sources told Buyouts.

Expectations are difficult to manage, and until buyers and sellers get comfortable with the new terrain, it’s reasonable to expect a standoff. And that means the industry will likely experience a slowdown, at least in the near-term, said Adam Sokoloff, Jefferies & Co. managing director and head of the bank’s Private Equity Coverage Group.

“Nobody likes to be the first guy to sell their business when multiples first begin to come down,” Sokoloff said. “They often need to see some stabilizing before they say to themselves, ‘O.K., we’ve come down to a new level, this is where prices are, and if I sell my business today, multiples won’t bounce back tomorrow and make me look foolish.’”

The reason for the falling leverage multiples: skittish institutional investors, who end up holding most leveraged loans these days. Investors who months ago salivated at mega-deals, gobbling up high-yield debt laden with light covenants and generous payment-in-kind provisions, are now turning up their noses at the securities. As a result, the buyout industry’s biggest lenders have essentially called a halt to debt offerings until after Labor Day, postponing or even withdrawing tens of billions of dollars in credit to back buyout deals on the hope that the investor appetite will return with the changing of the leaves. In the case of Cadbury Schweppes, which was seeking a financial buyer for its beverage division, the company indefinitely postponed the auction.

In the meantime, banks are stuck temporarily or permanently with huge bridge loans and other obligations they expected to syndicate off their balance sheets—$12 billion for Cerberus Capital Management’s takeover of Chrysler, to cite one example. PIK-toggle notes, which allowed companies to postpone debt service in exchange for taking on more debt, were hailed as state-of-the-art just a few months ago. They’re now dead for big deals, sources told Buyouts. And that means LBO firms will be on the hook for more cash to meet debt payments, which will likely bring down leverage multiples even further.

Slowdown Upon Us

Buyers and sellers are going to have plenty of time to contemplate where prices will eventually settle out. Much of the market for buyouts is backlogged.

Even if it’s easier in the present climate to assemble a mid-market financing package than a mega-deal debt facility, many times it’s the same bulge-bracket banks underwriting both loans. And with these banks awash in paper, they’re trying first to get rid of what they have on their books before turning their attention to new commitments.

“We’re getting caught up in what’s happening with the large deals,” said Ira Kleinman, senior managing director of Harvest Partners, the New York-based mid-market LBO firm. “The difficulty the banks are having in selling the multi-billion dollar loans is impacting the middle market, too, even though the dollar amounts are not as large. It’s going to be slow for some time, but I think in the longer term the credit market will rebound as these deals eventually work their way through the pipeline.”

What’s more, the big banks are so eager to move their stalled credit deals off their balance sheets that they’re willing to accept 96 or 97 cents on the dollar for loans. That has turned managers of collateralized loan obligation funds, who previously bought up the loans used in mid-market deals, into bargain hunters for large-market debt, where the fees are still higher, said Tim Eichenlaub, senior managing director in the sponsor finance division of mid-market lender CIT Inc.

To entice those CLO fund managers to play in the mid-market, buyout firms will have to increase the interest rates on loans. Earlier this year, a mid-market deal might have been be priced at LIBOR plus 200; now those same packages go for LIBOR plus 375. “You have to price it up,” Eichenlaub said.

Eichenlaub predicts that, as CLO funds move to the sidelines, banks and other lenders will step up and keep more loans on their balance sheets. Unfortunately for buyout shops, the loans will contain more bank-friendly terms and conditions, Eichenlaub said. For example, it’s reasonable to expect banks to afford management a 15 percent to 20 percent cushion on EBITDA projections, whereas during the recent looser times, the cushion ballooned to as much as 30 percent, he said.

None of these changes is “draconian,” Eichenlaub said. “We’re still certainly open for business, and the middle market is generally open for business.”

Still, the speed with which the credit markets turned has caused some whiplash among buyout firms. “If you’re trying to get a deal done right now, it’s a bad thing because you’ve got commitments, and you’re trying to close based on terms that you’ve been working on for the past three to six months,” said J.P. Conte, chairman and managing director of Genstar Capital in San Francisco.

More trouble could be on the way if default rates pick up and lenders grow even more wary.

Although default levels remain near historic lows, stress is starting to show on some of the companies that were over-levered in this credit cycle. According to Steven Ellis, a partner at law firm Proskauer Rose LLP whose practice areas include junior capital, about 10 percent of the financing deals his firm has represented over the past year, including second-lien loans, are already in default. Of those deals, most have found hedge funds that are still willing to refinance the debt and buy out the original lenders. “But,” Ellis said, “eventually that will dry up and you won’t see so many hedge funds taking out some of these huge capital deals. Then you’ll see some softening in the lower markets.”

Until everyone—the buyers, sellers and lenders—acclimates to the new credit world, the prevailing mood will be one of caution. “The credit markets are basically repricing risk, period,” Conte said. “A month ago the world was different, and now they’ve repriced it substantially.” He added: “Long-term, I think it’s a good thing for the private equity business. It’s throwing a nice bucket of cold water on an overheated system, and ultimately it will help bring prices down.”