The Deals Just Keep Coming And Coming –

After putting up near record numbers in deal volume last year, LBO sponsors seem intent on proving that 2003’s $94.6 billion in disclosed transactions was no fluke. In the first half of 2004, U.S. buyout shops are on pace to eclipse 2003’s number, completing 331 deals worth a combined total of $58.8 billion in disclosed values. And there is not expected to be any let up for the third quarter, as more than $30 billion worth of disclosed deals have already been agreed to and are now awaiting completion.

In the LBO world, most point to a juiced financing market to account for the dramatic jumps in deal volume. And with the robust lending environment pushing purchase prices higher, sellers have re-emerged from the shadows, confident that their expectations will be met.

While few will admit it publicly, some believe private equity’s flight to quality has had its wings clipped amid 2004’s competitive environment, and the availability of debt today has given some seemingly unexceptional companies valuations that border on being fulsome.

Leonard Green & Partners John Baumer, a partner at the firm, is one buyout pro that believes the availability of debt has turned the M&A landscape back into a sellers’ market. “We’ve seen a lot of sellers emerge that had probably been holding off over the last year or two given the economic uncertainty. There’s a fundamental disconnect in the market, where quality assets are receiving fairly rich multiples, around 8x [EBITDA], but that’s not necessarily unreasonable. What we’re seeing now, though, is that medium- to low-quality assets are right behind that, often selling for 7x or even 8x [EBITDA], and that makes no sense.”

It is no secret financial buyers today have ceased tailoring their deals with 30% IRR expectations. The crowds often found vying for the same assets make it almost impossible to win a deal with such lofty calculations in mind. And despite the lowered projections, most IRR forecasts assume some sort of improvement in company performance, rather than simply relying on financial engineering or multiple expansion.

“I don’t know any LBO buyers with 30% IRR expectations anymore,” Apax Partners COO and Partner George Jenkins says. “That’s just not the reality today. People are trying to pencil out low 20% returns in highly competitive deals.”.

Piper Jaffray Managing Director Jeff Rosenkranz notes, “The interest-level has become much more focused than in years past, even versus one or two years ago. Folks now feel they need to have an angle. It’s one of the challenges firms face: With so many sponsors out there, they need to find ways to differentiate themselves.”

An Eclectic Offering

Even as individual buyout shops narrow their spectrum of focus, the breadth of the entire industry has seemingly widened, leaving virtually no sector untouched by private equity investment. From technology and telecom to healthcare and manufacturing, nearly every industry has received attention from buyout shops in the first two quarters of 2004.

The $2.05 billion sale of Electronic Data Systems’ UGS PLM subsidiary to Silver Lake Partners, Warburg Pincus and Bain Capital served as a bellwether transaction for deals in the tech space, while the safety found in healthcare continues to endear the sector to financial sponsors. Three notable transactions from the healthcare arena include Welsh, Carson, Anderson & Stowe’s $1.7 billion taking-private purchase of U.S. Oncology; Clayton, Dubilier & Rice’s $1.68 billion carveout of Merck KGaA’s VWR International; and the secondary buyout of Iasis Healthcare, in which Texas Pacific Group paid $1.4 billion for the former JLL Partners portfolio company.

Barrington Associates Managing Director Eduard Bagdasarian notes, “Equity sponsors are trying to differentiate themselves, and they’ll do anything that allows them to gain a competitive edge. Because of this, firms are also looking at things that they haven’t looked at in two or three years.”

He cites private equity interest in the agricultural sector as one novel area that has generated private equity interest, and is corroborated by Fox Paine & Co.’s acquisition of seed maker Advanta BV. Last year also saw Fox Paine’s investment in Seminis, another seed maker but a separate platform than Advanta, and Heritage Partners’ recap of Sunrise Growers, a supplier of strawberries.

Bagdasarian also mentions business services, branded consumer products and the health and beauty spaces as other areas of intrigue for financial buyers. “For the most part, people are looking at the demographic and long-term [aging] trends, and we’re also seeing firms seek out businesses that are not vulnerable to foreign competition,” he says.

Why the Rush?

The surge in deal flow should not come as much of a surprise to those that have followed the industry for the past five years. Soon after a rush of fundraising activity near the end of the 1990s and in 2000, private equity buyers, flush with cash, were left with nowhere to spend their money once sellers vacated the market during the economic downturn.

In Buyouts’ year-end issue for 2001, in an article entitled “Buyout Deal Volume: How Low Can it Go?,” GPs voiced complaints about the mass exodus of sellers amid company performance issues and a pronounced dip in valuations. One GP told Buyouts at the time, “2001 was as bad as it gets…It’s just one of the periods that is counter-cyclical. The people feeding off growth are starving.”

Two thousand and two marked a return to the deal market for some, but it really wasn’t until the second half of last year and the first half of 2004 that buyer and seller expectations really squared. And firms, with their investment windows getting smaller after the prolonged recess, now have to put money to work in order to keep pace with their investment guidelines.

“I certainly think [approaching deadlines] are a factor for some firms,” William Hobbs II, a partner at Carousel Capital, says. “Funds typically carve out five to six years to invest their money, depending on the legal structure. There was a lot of money raised in 99 and 2000, and given the slow rate of investment in the past couple of years, it has caused people to pick up their pace.”

One GP, who didn’t want to be quoted, notes, “LPs are really taking a hard line on giving extensions. Firms don’t want to lose access to capital or lose management fees, and if your investment period runs out and you don’t raise a new fund, you’re effectively out of business… Some firms today are willing to accept a return that’s below market. There’s a certain amount of rationalization for these guys in order to put money to work. They convince themselves that they’re taking on less risk, which allows them to accept a lower return.”

On the other hand, The Audax Group’s Jay Jester, a senior vice president at the Boston firm, believes if there is anyone feeling the heat to put money to work, it would more likely be the firms intent on raising a fund in the immediate future. “There are going to be a lot of funds deployed in the next six to eight months, so there’s a race against the fundraising market to some degree. A lot of people feel that it’s better to be in the market with a fund sooner rather than later.”

However, he stops well short of saying that buyout activity is being driven solely by a desire to launch new funds, and ultimately points to the industry’s facilitating environs. “Everybody will look back at the past three and a half to four years and say, I wish I was buying like crazy during that time,’ but you have to remember, there was no financing back then and there was much more uncertainty in the economic picture,” Jester describes. “There is a pent-up supply of capital that’s getting deployed and multiples have expanded, but if you can get four and a half times leverage, then you’re not necessarily paying an unreasonable price for a company. It’s a much friendlier environment [for getting deals done] and it’s time to make hay while the sun is shining.”

The Road Ahead

As the LBO marketwatchers look into their crystal ball, the picture of what to expect for the second half of the year remains murky. Some feel financial sponsors will continue to harbor their current zest for doing deals, while others expect to see some retrenchment from the LBO players. Then there are those who believe the economy’s glow could just be the product of election-year energy, and are unsure exactly what lies ahead.

“We think there will be a little moderation in the second half,” Bob Filek, a partner at PricewaterhouseCoopers’ Transaction Services group, says. “The high yield market is seizing up a bit, and that has been a source of strength for private equity funds.” He also warns that if interest rates continue to rise, it will become increasingly difficult for buyout shops to harness the high yield market, which will hurt given the escalation of purchase prices.

And if firms are worried about valuations being high now, a possible march into M&A by the corporate buyers could send private equity running for the hills. Buyout shops have pretty much had their run of the land in the market the past couple years, but there is increasing evidence that strategic buyers are making their way back, and that development would undoubtedly push prices even higher. “The financial buyers have to really weigh more seriously their capacity to win against a strategic,” Jenkins says. “[Their return] will make firms more thoughtful about which deals they chase. In any one of these transactions, you can have several millions of dollars committed before you know if you have a chance at winning.”

With all of that said, though, many pros don’t see the financial sponsors coming up for air anytime in the near future. “It all boils down to confidence,” Jenkins says. “Look back over the past 18 months and you can clearly see the economy was growing more than anyone thought. So now you’ve got sellers that want to sell into an improving market, banks that are still lending aggressively and buyers that are clearly more confident.”