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Piper Jaffray: Good Times Roll Despite Excess Capital, High Multiples –

Editor’s Note: Last month, the Buyouts staff sat down with Glenn Gurtcheff and Jeff Rosenkranz, co-heads and managing directors of the Piper Jaffray Middle Market Mergers & Acquisitions Group. The following is an excerpted version of the conversation, which will run in two parts.

What are you seeing right now in the market?

Gurtcheff: There are an awful lot of bull investors out there. Everyone is optimistic about the direction of the market, and we share that optimism. Deals are getting done more rapidly than they have in the past, and there are a lot more alternatives sitting in buyers’ inboxes.

Rosenkranz: Last year, the message was cautious optimism. We expected the market to improve. Now when we look back at what happened in 2004 and look to 2005, everything is going better than we had hoped and we have no reason to think it won’t continue in 2005. Deal flow is way up and it is definitely a seller’s market. There has been a confluence of perfect storm-type of events that has led to a terrific market.

What creates the perfect storm scenario?

Rosenkranz: There is a combination of an aggressive lending market, private equity firms-that have a tremendous amount of capital- taking advantage of those markets, the economy is better than it has been in the last two or three years, and companies can perform at higher levels than they had been. There has also been the re-emergence of the strategic buyers that we have not seen in years. Those buyers who were absent are not only taking our phone calls now, but are proactively trying to assert themselves in processes.

But are the strategics proceeding with caution?

Gurtcheff: No, in fact, they are acting very aggressively. They are trying to pre-empt processes and making unsolicited outbound phone calls to targets. Adding to the perfect storm is that most groups have owned an asset one year longer than they expected, so you also have all this pent up liquidity demand.

So, in terms of the cycle, you don’t think we are at our peak yet?

Gurtcheff: I don’t think so. I suppose you could take the view that storm clouds are on the horizon; things like commodity prices could have a negative effect on our clients and our processes. You just have to keep an eye on the storm and figure out which way it is going to blow. And we don’t think the storm is blowing in. That is how we have looked at it. At the end of 2003, there was a huge surge of pitch activity. In the first quarter of 2004, firms were cleaning up things from 2003. Then the second and third quarters went nuts in terms of deals getting done. Deals just started falling down left, right and center, and this fourth quarter is looking exactly the same as 2003.

Rosenkranz: It all bodes very well for an active first half of 2005. If you look at the backlog of deals in the pipeline, it is clear that there is a lot more deal activity now. We think about the peak, but it is not here yet. There continue to be so many positive factors and with the tremendous amount of money out there looking for a home, we believe this market has more running room.

Is there too much money in the hands of private equity firms?

Rosenkranz: The excess capital in the market has led to lower returns, but so has the maturation of the private equity market. The market has become institutionalized. You will not see the same returns you saw ten years ago in private equity, but 15% or 18% returns are still pretty attractive and will continue to draw dollars into this market.

If LPs chose to put their money elsewhere, where would they get those types of returns?

Rosenkranz: All returns have come down. Public returns have come down, which again is really just a maturation of all these markets. Private equity returns are going down now, but they are still at a level where there is no shortage of money coming into the market. Firms are raising billions of dollars.

Gurtcheff: Even though returns have come down, the spreads are not that different in terms of private equity returns versus S&P and other benchmark returns. If you look at that particularly difficult period we just came out of, everything shifted down, but a lot of private equity firms still performed well. I think there will be a little stratification in terms of winners and losers in the private equity market-first-time funds that did not perform will and probably should find it difficult to raise larger funds. But for the most part, firms that have a good track record will raise new funds. And it is okay if they can’t all raise new funds because there are plenty of funds out there.

Are there too many private equity funds out there?

Rosenkranz: I would say yes, but I don’t think that has anything to do with how much is allocated to the class. It’s just a question of whether there are 700 private equity firms investing those dollars or 350 firms each investing more dollars.

Gurtcheff: I guarantee every single week Jeff Rosenkranz, John Hogan and I each get a call from a private equity firm we have never heard of saying, “We’re calling to introduce ourselves-we’re brand new.”

Rosenkranz: The calls usually go something like, “Hi, I am Bob Smith. We just raised $300 million and we are a middle market private equity fund with a unique strategy that wants to invest in strong management teams with great cash flow.”

Will you send books to those guys?

Gurtcheff: Generally, no. The challenge guys like us have is that there are so many private equity funds; we really need to pick our spots. We can’t send out 200 books to private equity firms, and even if we did, we would only be covering half the private equity firms that might be willing to do the deal. We work hard to bring the right firms to the deal based on our knowledge of who is going to be the right fit, be able to pay up and who is going to be there at the close. Value creates a point of entry, but a lot of firms can pay an appropriate price. We measure someone’s ability to get us comfortable that they are going to be there at the closing.

Do you shop deals to the same firms over and over again because those are the ones that get the job done?

Gurtcheff: We probably err on the side of being a little more inclusive when we are talking about prospective buyers. You can’t always predict who is going to rise to the bait. You might put the book into their hands, ask for their indications of interest and sometimes you nail one and you know they are going to chase the thing hard and sometimes they take a pass. It is difficult to place people in categories at the beginning of the process. But what you can do, when you have all your indications of interest, is tell your client that if they blow the management presentation there is going to be a problem because all the relevant people are seeing the deal.

The management presentation is what we call our most valuable real estate. This is also when the client looks at us and says, “Who are these guys, how well do you know them, what have they done in prior processes, do they stay to the finish, have they been doing the work, are they asking the right questions?” A private equity firm distinguishes itself by doing the work, showing a ton of interest, by digging and making sure we see their interest level. When we offer someone a chance in one of our processes, they should play hard and fair such that when clients ask us these questions we can say, “These guys have been there and are doing the work.”

Characterize the quality of deals you’re seeing.

Rosenkranz: They are high quality. If you go back a couple of years ago, great companies were getting sold in bad times and they were getting great multiples. It is not quite the same as it was then. There are so many companies out there and they are not all A+ companies, but they are B+ or better. We are not seeing a bunch of C or C+ companies going to market and getting great prices.

Gurtcheff: Two years ago you saw the really great companies get great deals done. If two years ago the A+s were getting high multiples, they still are today. The B+ companies are also getting high multiples and the world is coming to them. The confluence of events is making these companies attractive.

Rosenkranz: Beauty is in the eye of the beholder. Private equity firms are buying companies at whatever price because they think they can create value.

So in terms of overpaying, how bad is it? Is overpaying going to cause a big problem later on?

Rosenkranz: Private equity firms are paying full price, not overpaying. They have to, given the competition, but prices are not unreasonable and should not cause problems later because leverage multiples are still significantly lower than what we saw in the late 1990s. Companies are not as leveraged as they were seven years ago.

Gurtcheff: I had a conversation with a partner about what kinds of companies his firm buys and at what prices. He said he had done best with the companies he paid the most for. It is not surprising that the best companies perform the best and cost the most-it’s very logical. The partner said, “An extra $1 million is not going to make a difference, so if we see something we really like, we are going after it. You can’t worry about an extra million driving your return down a point; you have to be more concerned with buying the right company and backing the right management team. That is going to make this a better deal.” When we say people do not overpay, we really mean it.