Wall Street Crisis Squeezes Buyout Market

“We’re like everyone else, waiting to see what else happens, for the dust to settle,” said one industry observer. “There’s probably a lot of opportunity being created along with the turmoil. But right now, it’s still too early.”

In the span of just 48 hours, Lehman Brothers went from potential acquisition target to filing for bankruptcy protection, while Wall Street rival Merrill Lynch & Co. got snapped up by Bank of America for a cool $50 billion. AIG, a Dow component, teetered for days before a government bailout finally materialized. Taken in total, the firms’ exposure to private equity is extensive.

Factoring in the collapse of Bear Stearns just a few months ago, Wall Street’s five main independent investment banking firms have been whittled down to just two—Goldman Sachs and Morgan Stanley. And as the screens all over the world flash red, buyout pros are wondering how they’ll be affected. Is the wise move to bide some time on the sidelines? Or will those with the courage to make deals during such dark days be rewarded?

The feeling among many in the industry is that the loss of such heavy hitters will extend the pullback in the credit markets, leading to less leverage and worse terms, since fewer lenders will be competing for business. Deal flow isn’t expected to seize up, especially in the more debt-friendly middle market, but buyout firms may have to spend a lot more time tending to their portfolios than searching the landscape for new opportunities.

In the near-term, the situation with Lehman Brothers remains fairly fluid. At press time, British bank Barclays had agreed to purchase certain U.S. assets in a deal worth $1.75 billion. The company’s investment management business had been rumored to be a target of private equity investors for months but potential buyers such as Bain Capital and Hellman & Friedman never reached deals. The fate of other assets is fuzzy. Due diligence under these conditions will be a daunting task, to say the least, and there are myriad other issues to consider with employee retention, potential legal liabilities and the complicated nature of unwinding positions for liquidiation at the top of the list.

Lehman Brothers’s fund-of-funds group has committed more than $2.2 billion to roughly 270 private funds, according to the company’s Web site, while the merchant banking business employs 35 and manages total committed capital of more than $8 billion. It’s currently unclear what amounts have been drawn down, or the status of pending commitments. The firm’s M&A advisory services business would surely be attractive to the right buyer, if Barclays doesn’t retain it. The business ranks eighth in U.S. announced deals year-to-date in 2008, involved with 66 transactions with a total value net of debt of $127.5 billion, according to Thomson Reuters.

Meanwhile, the federal government has agreed to lend up to $85 billion to AIG in order to ensure the company can meet its liquidity needs. While the common stock continued to suffer, this should stabilize actual operations for the time being. AIG Investments, the company’s asset management unit, has about $29 billion in private equity assets and a staff of roughly 200. Acting as a limited partner, AIG has at least $10 billion in commitments to various private equity funds. The company also holds a roughly 7 percent limited partnership interest in The Blackstone Group dating back to 1998 that could be sold to raise cash. It also agreed to commit $1.2 billion to various Blackstone funds a decade ago.

The combination of Bank of America and Merrill Lynch brings a 49 percent stake in BlackRock on to Bank of America’s books. BlackRock’s fund-of-funds business, which incorporates the assets gained through the October 2007 acquisition of Quellos Group LLC, could be dealt with in a similar manner as a $1.9 billion portfolio of limited partnership interests that Bank of America sold to Conversus Asset Management LLC in the summer of 2007. Bank of America retains a 50 percent stake in Conversus.

On the investment banking side, the combined firms would be the top underwriter of global debt and equity securities. Together, Bank of America and Merrill Lynch have underwritten $45.6 billion in equity and $331 billion in global debt year-to-date, according to Thomson Reuters data. The pair would be second in global syndicated lending with $141.8 billion in loans. The merged company would also be more than formidable when it comes to IPO underwriting: Merrill Lynch is ranked first this year in U.S. deals, involved with seven issues generating proceeds of $3.69 billion, while Bank of America’s business in this area ranked fifth, thanks to four deals with total proceeds of $2.78 billion.

Credit Crunch Extended

Buyout shops expect to see further weakening of the credit markets while they search for ways to confront uncertainty of how far prices will fall. Josh Lerner, a professor at Harvard Business School, expects the takeouts of Lehman Brothers and Merrill Lynch to lead to less attractive financing terms for buyouts, adding fuel to a trend than began with the advent of the credit crunch in mid-2007.

“There’s been a real symbiosis between investment banking and private equity,” Lerner told Buyouts. “In a world with fewer IBs out there competing for business, there’s going to be less availability of capital on super-generous terms. The age of hyper-competition for business with LBO shops has gone away.”

The status of Lehman Brothers in particular may come into play here. The company’s private equity businesses include operations in European mezzanine debt and collateralized debt obligations as well as leveraged loans. The firm’s Loan Opportunity Fund closed in October 2007 with about $3 billion, inclusive of its targeted leverage.

As a result, Lerner expects to see more buyout firms bring some underwriting in-house. He also believes some firms might even be forced to hand some funds back to their limited partners. The feeling being, if they aren’t going to pull the trigger now, when will they do it? He likened the situation to what happened with many over-funded venture capital firms after the Internet meltdown in 2000-2001.

Steven Kaplan, the Neubauer Family Professor of Entrepeneurship and Finance at the University of Chicago, was blunt in his assessment of the situation. “PE activity will not resume in earnest until the banks are lending in earnest,” he told Buyouts via e-mail. “And the Lehman/Merrill/AIG turmoil indicates that the banks are not going to be healthy anytime soon.”

The historical significance of these events was at the forefront of the thoughts of many buyout pros. “These events sharpen the mind,” was the reaction of Bela Szigethy, the co-CEO of The Riverside Co., a mid-market buyout shop based in Cleveland that has stayed relatively active this year. He noted that the equity component of deals has crept up. “There’s just not a whole lot of “L” left in our “LBO” right now,” Szigethy said. “But then we’ve always been a lot less levered than our larger brethren.”

Were deal volume to fall, it would mark a slowdown from already depressed levels. The year-to-date disclosed value of transactions sponsored by U.S. buyout firms is just over $100 billion, less than half last year’s pace, while interest in big transactions remains stalled. Tony James, Blackstone Group’s president, speaking at a conference earlier this month, said the firm isn’t getting bank financing to do deals over $5 billion in size.

There is also the impact of a weak economy on portfolio companies to consider. Difficulties there will create distractions for general partners, slow exits and depress returns. Fluctuations in interest rates – witness the recent volatility in LIBOR – will also add pressure as most senior loans have floating rates tied to the cost of borrowing overnight funds in the interbank market.

“The events of the last few days are certainly sobering,” said Mike Guthrie, a managing director with Palo, Alto, Calif.-based Symphony Technology Group, adding: It’s very difficult to predict the long-term effects on the overall economy, so we’ll be focusing a lot of attention helping our portfolio companies navigate through this environment. In terms of new deals, we expect that credit will become even tougher to obtain.”

Opportunities

Still, even as the crisis continues to play out, buyout professionals sounded at least two optimistic themes. Private sector purchase multiples, they point out, are bound to come down along with those in the public markets. And activity in the middle market should hold up because financing for these deals is less dependent on the big investment banks.

There is also still plenty of overhang from the high fundraising levels of the past two years. For many firms, getting further limited partners commitments, at least in the near-term, isn’t a huge concern just yet. “The best times to buy companies are when it’s dark and cloudy,” said Riverside’s Szigethy, whose firm is out raising a new fund. “Everybody knows it, but not everyone can do it.”

“I’ll be interested to see what opportunities there are,” said Larry DeAngelo, founder of Atlanta-based Roark Capital Group, noting that the firm’s companies are fully financed and that the shop won’t need fresh capital any time soon.

Randy Schwimmer, senior managing director and head of capital markets with Churchhill Financial, said middle-market lenders like his are still looking for good deals, but capital structures are likely to get more conservative. His firm, a senior and mezzanine lender whose investments typically range from $5 million to $30 million, has what he termed a “healthy” pipeline of deals, mostly small LBOs with target companies boasting annual EBITDA in the $15 million to $25 million range.

“The middle market should get a lot of attention in this environment,” Schwimmer said. “Our PE clients are focused on putting money to work with market leaders in niche industries. These companies are better platforms for growth and add-ons. We may see a lot more cases of survival of the fittest as this plays out.”

Charles Cherington, the co-founder and managing partner of Intervale Capital, a middle-market player in the energy sector, said it was still business as usual at the firm. “Where this all leads, we really don’t know, but I think the banks making loans to buyout firms will continue to do so,” he said, adding the caveat that the sector a firm is focused upon will likely influence its ability to secure financing.

Mark Bradley, the global head of Morgan Stanley’s Financial Sponsors Group, while somewhat concerned by the latest developments, has the view that this meltdown will make for a very interesting deal-making environment. “No matter how ugly it seems today—the red screens, good firms’ going bankrupt or being bought out, and everyone gawking at the train wreck, it [the deal market] will creep back and the survivors are going to come out of this with bigger market shares,” he said, referring to the other lenders.

Bradley sees the timeframe for a return of very large public-to-privates as anywhere from six months to two years. “People will re-trench,” he said. “Multiples will come down and this will set the stage for the next cycle.”