Sponsors Rock Down Through The Exit Avenue –

As the M&A landscape transposes from a buyers’ to a sellers’ market, private equity firms are becoming more opportunistic in finding exits. The timing of this shift couldn’t come soon enough.

Slumps in portfolio-company financials, a retraction in valuation multiples, a prolonged retrenchment from strategic buyers and a nonexistent IPO market had all conspired to make the past couple years one of the most barren exit environments financial sponsors have seen in some time. But now that every one of those factors have reversed, or at least shown substantive signs of turning, and firms are shifting into full exit mode. “It’s a very good time to be a seller,” Leonard Green & Partners’ John Baumer says, adding that it could also be advantageous at this time for sponsors to take a step back from new investments, at least while the buyout market remains overheated.

Big Ups to the Stock Market

A sustained firming in the public markets has probably had the biggest influence over the exit environment. Carlyle Group Managing Director Allan Holt, says, “As the stock market gets stronger and the economy continues to grow, the corporate acquirers will start to return. We have already seen this start to happen.”

To be sure, in the past year, private equity has found itself benefiting from a ramping up of strategic M&A activity. Leonard Green is among those that have already taken advantage of this, with the firm’s sale of White Cap Construction Supply to The Home Depot. Among others happy to see the strategics return, Clayton, Dubilier & Rice also turned to a corporate buyer when the firm sold Kinko’s to FedEx Corp., while Wind Point Partners relied on the renewed corporate vim to exit Pacific Cycle through a sale to Dorel Industries.

In addition to the strategic interest that comes out of the stock-market’s headway, the IPO window tends to open up as well, and private equity’s activity has so far been the canary in the coal mine, testing just how strong the market thirst is for new public offerings. (See box). In the past couple months, S-1 Filings came flying in from GNC Corp. (an Apollo Management portfolio company), Polypore International (Warburg Pincus), THL Bedding Holding Co. (Thomas H. Lee Partners), Domino’s Pizza Inc. (Bain Capital), Dex Media (The Carlyle Group and Welsh, Carson, Anderson & Stowe) and Kindercare Learning Centers (Kohlberg Kravis Roberts & Co.).

While all of these IPO candidates are still just a twinkle in the market’s eye, there have been a few unequivocal success stories. Cerberus Capital Management reaped gold from the floatation of Teleglobe International Holdings, which earned the firm a reported 270% unrealized gain, and the IPO of Cabela’s Inc., another bonanza, yielded a roughly 3x return on investment for JPMorgan Partners. Not all private-equity offerings have been unmitigated victories, however. Worldspan Technologies, a portfolio company of Citigroup Venture Capital and Ontario Teachers’ Pension Plan, has had to trim its price range, and on the last day of June, decided to postpone the floatation, citing usual-suspect “market conditions.”

In today’s exit market, though, where the buying interest from corporates and financial sponsors rivals that of the public, an S-1 filing can simply be a predecessor to a complete exit through a sale. Britain’s Doughty Hanson, for one, was bailed out by KKR, when the New York-based shop agreed to buy Doughty’s German auto parts retailer, ATU, allowing the firm to achieve a 3.5x return on the investment. Conversely, after filing to float Borden Chemical in an IPO, KKR decided to sell the company outright to Apollo Management in a $1.2 billion deal, allowing KKR to clean its hands of the roughly 9-year investment.

Firms today will increasingly pursue a dual track approach when seeking exits, filing for an IPO to smoke out potential interest in a company. JLL Partners found success this way in its exit of Iasis Healthcare. The firm hired Goldman Sachs & Co. to pursue both scenarios and ultimately opted for a sale to Texas Pacific Group, which paid $1.4 billion for Iasis. Madison Dearborn Partners, meanwhile, is currently pursuing a dual track approach with a planned exit for its Carrols Holdings Corp. portfolio company, a franchisee of Burger King restaurants.

Carlyle’s Holt notes, “This isn’t necessarily a new thing. You try to keep your options open. But you must have a viable exit under both scenarios to go down that path. Then it’s just a question of where you will get the highest valuation. Many times you don’t know until you file an IPO.”

Trusting Your Peers

While the public markets have given private equity firms flexibility in finding exits, the most reliable opportunity to find realizations these past few years has been sponsor-to-sponsor sales. As JLL’s Iasis exit demonstrates, private equity firms, with financing on their side and $95 billion of dry powder at their disposal, still provide one of the more preferable options through which to exit, at least while the strategic buyers continue to step gingerly back into M&A.

The sale to another financial sponsor, at one time frowned upon, was the predominant outlet these past few years. In the first half, the secondary sale of movie theatre chain Loews Cineplex Entertainment to a consortium of PE buyers brought Onex Corp. and Oaktree Capital Management a roughly 2x return on their investment. Providence Equity Partners, meanwhile, achieved a 7x return through the sale of Language Line Services to ABRY Partners, while The Carlyle Group saw the value of its Horizon Lines container shipping company more than double in just over a year in its sale to Castle Harlan.

Have Debt, Will Recap

Buyout shops have also been quick to seek out dividend recapitalizations on portfolio companies as a way to return money to their limiteds. Just as the strong debt markets have bolstered secondary buyers, the same financing markets have made the dividend recap a fashionable way to grab a return while holding onto much of the original equity in an investment.

“As long as you’re prudent about it and the company can carry the additional debt, a recap makes a lot of sense,” Holt says. “We’re always evaluating whether to do a dividend recap or seek out a traditional exit. It comes down to, for us, how long we’ve held onto a particular company and where we ultimately intend to go with it.”

Among the recap triumphs in the first half, Trivest Partners took back an $87 million dividend through its recap of Directed Electronics, while Berkshire Partners will see a $153 million payday, according to reports, from a recapitalization of Holmes Group.

However, not everyone is a fan of the leveraged recap, and there are those that feel some investors are taking advantage of the maneuver at the expense of a company’s overall health-at least when investors go back to the well more than once. The Teachers’ Retirement System of Louisiana made these claims in a lawsuit against Regal Entertainment Group to prevent investors Philip Anschutz and Oaktree Capital Management from receiving a $710 million dividend in their $1.75 billion recap of the company. The injunction was ultimately refused, but others have weighed in as well, with Moody’s Investors Services saying, “The company continues to pay out more in dividends than it generates in cash.” Both Moody’s and Standard & Poor’s slashed their ratings for Regal’s bank debt on the recap news.

Exits Galore

The theme in the exit market today, a theme most investors will surely revel in, is that for the first time in quite a while, LBO investors have a choice on where to pursue an exit. Every road can be taken right now, and since nobody can tell just how long it will be until this window is shuttered, sponsors are intent on finding exits.

Also, as if investors needed an extra push, sponsors are again beating a path on the fundraising trail (see story, page 1). With LP’s increasingly fastidious, if buyout shops want to raise a fund, they better not show up at the limiteds’ doors without a track record.

One GP with an eye for bargains is happy to see firms in a pinch to sell. “There’s quite a few funds out there selling because they need to book some wins to help further the fundraising process. A lot of times fellas are selling before they should and this is an area where we like to play, when an investment has not been fully optimized and there’s a motivated seller,” the source says.

Whatever the reasons for seeking an exit, it is clear buyout firms will continue to play an integral role in M&A, although in the next year, it may be from the sellers’ seat. Barrington Associates Managing Director Eduard Bagdasarian, says, “There has been a significant uptrend in the number of sponsor-owned companies being offered for sale. In the past it probably represented about 20% of the deal flow we used to see, but now sponsor-owned sell-side mandates represent about 30% to 40%, and I expect that to continue.”