Editor’s Note: In March SSG Capital Advisors, L.P. sponsored an industry roundtable discussion that was moderated by Editor Danielle Fugazy. The following is the second part of an excerpted transcript of the discussion. The first part ran in the April 12, 2004, issue of Buyouts.
The participants were:
Thad Johnson, Director, Merrill Lynch Capital
Kenneth Jones, Principal, American
Richard Levenson, Senior VP, Bank of America Business Capital
Christopher Reilly, Partner, Saunders, Karp & Megrue, L.P.
Robert Smith, Managing Director, SSG Capital Advisors
FUGAZY: Thad, Merrill Lynch is a relative newcomer to this business, how do you differentiate yourself?
JOHNSON: A year or so ago, when there wasn’t the same level of liquidity that there is today, we positioned our group as the lender that would respond very quickly and keep the borrower informed as to where we are in our process and how we were evaluating an opportunity. We also assured borrowers that if we did offer terms and conditions under which we were willing to move forward, we wouldn’t deviate from that. There would be no surprises at the 11th hour.
We still compete on that basis, but now that there is more liquidity plowing into the market, we need to be even sharper on pricing and leverage.
JONES: One point of differentiation for American Capital is that regardless of whether it’s our own deal where we act as the sponsor, or whether someone else is the sponsor, we can look at the equity underneath the deal and the senior debt on top of it. We have very flexible capital, which can be deployed in senior, sub, or equity at any one time, as long as there’s a piece of mezz.
SMITH: Many of our clients at SSG Capital Advisors do not have readily identifiable access to capital. So although we look for institutions that can provide us with a quick yes or no, it is more important to find institutions that can work with us to identify an innovative structure. This presupposes that the institution will be flexible, regardless of whether it’s a senior lender, a hedge fund, or a mezz lender.
FUGAZY: Let’s pursue this flexibility idea a little more. When you find financing sources that are more flexible, do you tend to focus on those institutions, perhaps to the exclusion of other lenders?
REILLY: When there’s a tremendous amount of liquidity in the marketplace, users of capital such as Saunders, Karp & Megrue are always in a better position. When there’s a lack of liquidity, like there was 18 months ago, we’re in a less favorable position.
Today, we have a wide range of institutions that we can approach. As you would expect, we tend to go to the people that move quickly and are competitive on pricing, but are good to work with and can provide the value added that flexibility implies. Once you have found people who meet these attributes, there’s a clear advantage to working with them again.
On the other side, when there is minimal liquidity in the marketplace, you’re pretty much calling on whomever you can get to participate in your deal. If they’re not prone to being flexible, we may still have to transact business with them. These lenders can obviously capture “excess returns” when liquidity is tight.
LEVENSON: In today’s very liquid environment, Chris, I would think that you can place the different layers on the right side of the balance sheet, rather than just getting the transaction done and then right sizing the different pieces as you go.
REILLY: Absolutely. Today, it’s a la carte, and we can pick and choose among the asset based, cash flow or mezz lenders as we see fit. We are much more in control of who and how the deal gets done. That’s a very different dynamic than it was 18 months ago.
LEVENSON: We are certainly seeing the financing of competitive M&A transactions evolve that way. The structure may change three times during the process as the price changes, because different pieces are filling different needs.
FUGAZY: Let’s change directions. What role does a workout strategy play in your business?
JONES: We basically have three principles regarding workouts. The first is that we do it ourselves and don’t hire anybody. We have a staff of 10 workout professionals on our payroll. Half of them are operating principals, who parachute in for CEO, COO kind of jobs for deals that aren’t working. And the other half are financial professionals.
The second principle is that we’re not afraid to throw more money at a workout situation. We have come to the conclusion when you have solid companies that were poorly managed or in a bad market, this often results in throwing good money after good, not good money after bad.
The third principle is that we’re not afraid to own. To a great extent, that speaks to our operating mentality.
JOHNSON: One of the benefits of our group being around for only two years is that we don’t need a full-fledged workout strategy yet. Having said that, there are two credits in the portfolio that haven’t performed, and they continue to be managed by the professionals that actually booked them. However, we recognize that not everything in the portfolio will perform well, and so we’re evaluating right now when and to what extent to staff up with in-house workout professionals.
LEVENSON: It is not our practice to move a loan to a workout area. We build a relationship with the management of the firm, and it should stay fluid throughout the life of the loan. An asset-based workout mentality is much different than what I’d call a bank workout. The primary goal of bank workouts is reduce exposure, reduce exposure, reduce exposure. We are not necessarily afraid to increase exposure in a workout to ultimately achieve a better outcome for everybody in the group.
There is an impression that goes back 20-30 years that asset based lenders were liquidators, and liquidation is generally the absolute last resort as a method to get a loan repaid. Most of the businesses that we finance have a reason to exist in some way, shape, or form. What generally has to be done is to find the core that really does generate the cash in the business, and then use the non-core pieces to reduce debt and put the company in better shape. Our deal structures tend to lend themselves to early recognition of problems and then an opportunity to do a cooperative workout or rehabilitation.
The most prudent course may be for M&A professionals and other financial specialists to seek practical solutions. It’s an area where they have expertise to either sell off a less productive piece of the business to rescue the core, or sometimes sell off the core and try and fix the part that needs fixing, depending on the capital available and the structure of the transaction
FUGAZY: Chris, if your private equity fund has a portfolio company that’s encountered severe difficulties, what approach do you take?
REILLY: Every private equity shop has companies that have not performed accordingly, and we’re not exempt from that. Unlike Ken’s outfit, we don’t have the capacity or resources to address those types of challenges in-house. The individual on our team who originated that deal and who knows the company and its industry best will continue to stay in close contact with the management of the company, and monitor their performance. We will certainly enhance or add to the team with additional internal resources as appropriate.
However, we will almost certainly access outside assistance. We have found that to be an efficient approach, and is generally money well spent. Often times, there’s expertise that is not resident in the company, which is partly the reason why it’s having trouble. Many lenders become far more comfortable if we can find the right outside expertise.
LEVENSON: In general, Danielle, professional owners are quicker to face hard issues than sole proprietors. Family owned businesses almost always have a longer denial period. Professional owners are faster to acknowledge a problem, and may be more willing to accept professional help, or parental guidance, as I sometimes call it.
REILLY: Our job is to provide that guidance, Rich, because we are responsible for the company at the end of the day. In terms of our reputation, we can’t afford to simply bail out. We’ll fight right to the finish line on every deal.
FUGAZY: How would you characterize the quality of the deals that you’ve seen recently?
REILLY: It’s a great time to be selling businesses. It’s a good time to sell a quality asset, with the economy heading in the right direction, interest rates remaining at historical lows, and the M&A environment picking up. By definition, the quality of deals that our team talks about at our Monday meeting is both up in number and up in the actual quality. That said, I think it’s becoming more difficult to actually get one to the finish line.
JOHNSON: We agree that the quality is definitely up. eighteen months ago, exit multiples were at a significant discount to the exit multiple a seller can get today.
LEVENSON: The deal quality is better today as a function of consolidation. The economy has shaken out businesses that really shouldn’t have been around anymore, marginal businesses. Management has been shaken through, and you’ve got a better quality of people that have survived the downturn. And certainly, from a capital perspective today, they’re much better capitalized. We no longer see LBOs that are done with impractically small equity contributions.
JONES: Firm-wide volume is up significantly, but in terms of quality, I would take a slightly different tack than my brethren around this table. I agree wholeheartedly that it is a good time to be selling a business. However, EBITDA was significantly down in ’03 over ’02 in the last three situations that came across my desk. So I really don’t see much quality flowing our way, and our latest 12-months approach raises some serious questions. Clearly, these three deals came to market because their bankers told them that this was a good time to sell. However, because these three opportunities on my desk are less-than-quality, we might be able to pay a reasonable number for them, rather than 6x to 8x.
JOHNSON: You may be able to argue that our portfolio is somewhat of a bellwether of overall performance in the middle market. We have 200 names in the portfolio, and 75%-80% are performing at flat or better versus the prior year. Admittedly, a lot of them are flat, but a year ago there were a greater number that were down. So, things have stabilized for us in the middle market and potentially, there’s an upward bias developing that lends itself to quality.