Uncertainty Cools Mid-Market Exit Climate

Sale prices are still strong for companies valued at less than $250 million. But LBO shops are putting only their most attractive companies on the block, sources told Buyouts. Businesses showing any hair face a much cooler reception, particularly from lenders, underscoring the uncertainty that now pervades the market.

“I think it really depends on the company,” said Rob Newbold, managing director of Graham Partners, which last month sold a portfolio company, Dynojet, to American Capital Strategies, in a deal that was initiated just at the onset of the credit crunch. “Good businesses are trading for high multiples. Mediocre businesses are having a tougher time.”

If the exit window earlier this year resembled a sliding glass door, it now looks more like a porthole. For the three months ending Nov. 26, the number of announced deals for portfolio companies owned by U.S.-based sponsors was the lowest for any three-month period in nearly two years, according to Thomson Financial, publisher of Buyouts. The announced exit volume was also down more than 40 percent compared to the white-hot three month period between March and May of this year, according to Thomson Financial.

“It was as friendly an environment for M&A as you’re ever going to see,” Glenn Gurtcheff, managing director in the Minneapolis office of sell-side adviser Harris Williams, said of the market earlier this year. The firm has advised on the sales of 18 buyout-backed portfolio companies in 2007, and all of the auctions got started before the summer debt swoon.

The narrower opening for exit opportunities could upset the virtuous circle that LBO firms have come to rely on. It’s a cycle that goes like this: raise a fund, buy companies, sell companies, return money to limited partners, raise a new fund, repeat.

Since every fund isn’t full of spotless companies, the tumultuous credit climate could force firms to hold on to companies for longer. Realizing gains quickly through a flip or dividend recap are off the table because of the shaky credit market, and many firms are actually going to have to roll up their sleeves and work on companies that need grooming before they’re ready to hit the auction block.

“You’re seeing that already,” said one limited partner of firms turning their attention to strengthen their existing portfolio. “In the small and mid-market, it’s just slower—the overall activity is slower as people try to figure out where this is going to end up. We haven’t been that long in the credit crisis to know for sure whether the traditional fundraising cycle will be lengthened.”

Seizing The Day

At the same time, some buyout firms took advantage of the frothy M&A market to empty their portfolios of exit candidates. For instance, Charterhouse Group, the New York LBO firm, exited five companies in 2007, and all of the deals were either completed or initiated before the summer credit swoon. As a result, Charterhouse Group netted a 3.3x multiple on the five companies combined, and, of the eight companies left in the firm’s portfolio, none is for sale, regardless of the market’s condition, said David Hoffman, a managing director of Charterhouse Group. The firm’s flurry of activity has set up a likely fundraise in 2008.

“We felt that multiples were out of whack, but all of these companies were ready to sell,” Hoffman said of his firm’s approach to exits earlier this year.

The environment is considerably different now. The number of mid-market lenders dwindled in August and September, and their ranks are only now beginning to return, bringing more liquidity along with them.

But with fresh news of continued credit turmoil arriving on a near-daily basis, the market hasn’t shaken off the sense of uncertainty that’s dogged it since the summer. What’s more, the economy appears to be hovering on the brink of recession, adding to the instability.

“It’s not just turbulence in the credit market. You sort of have a double whammy,” Hoffman said. “The exit climate is challenging right now.”

Many sponsors have put their auctions on hold, he added, contributing to a general slowdown in deal flow.

Contributing to uncertainty in the mid-market is the fact that buyers and sellers still haven’t aligned themselves in the new landscape. Sellers are generally still looking for prices above what the market is willing to pay, while buyers have come to view the downturn in the credit market as an opportunity to scoop up value plays. The two sides have yet to square.

What’s For Sale

That isn’t to say that exits in the middle market are nonexistent. It’s just that given the market volatility, buyout firms are putting up for sale those companies that are considered surer bets, sources told Buyouts. For those businesses, valuations are still strong and aren’t off considerably from the highs of earlier this year.

Paul Weisbrich, a senior managing director with advisory shop RSM Equico, said a company that would have sold for 9x EBITDA in the spring will still command 8.5x EBITDA now. Though not as high a valuation, it’s still proof that mid-market deal-making, for the right businesses, is chugging along.

“Companies with sex appeal and the right size are getting prices that two years ago would have seemed ridiculous,” Weisbrich said

For Harris Williams’s Gurtcheff, the market is reminiscent of the 2001-2002 period, when a similar sense of uncertainty gripped the buyout world. At that time, as now, attractive companies looked like deals of the century. “A good-looking company that performs well in a slow market leapt off the page,” Gurtcheff said.

Meanwhile, less appealing companies will find a cooler reception from potential buyers. “It can still get done, but you’re going to get hit harder on the valuation,” Graham Partners’s Newbold said.

And it’s an even more difficult climate for companies whose valuations would likely push bids above $250 million, he added. Sponsors looking to shop a business generating $40 million in EBITDA will likely hold off because of market skittishness, he said.

Consequently, firms that assembled a portfolio in the last three years and missed out on the golden window of exit opportunity may find themselves with little cash to make new investments and companies that aren’t ready to move.

That could pose problems for firms that have deployed most of the money they raised in recent years but have yet to realize many of their investments. Solera Partners, for instance, has drawn down most of its vintage 2000 fund but has, through June 30, returned less than 1 percent of that sum, according to data made available by a limited partner, the California Public Employees’ Retirement System. Likewise, Brynwood Partners, has drawn nearly all of the $5 million CalPERS committed to the firm’s 2005 fund; the firm hasn’t yet returned any of that money, according to CalPERS.