War To Cause Hesitation, Not Resignation –

While the start of Operation Iraqi Freedom has sent the public markets on a roller-coaster ride, with a rise or plunge at every turn in the conflict, in the private equity market the response thus far has been far less extreme, as most LBO shops are moving forward with business as usual. To be sure, there are still the obvious questions about the war’s effect on the economy and what will happen if the war campaign is protracted, but most buyout pros seem to be taking a wait-and-see approach, with the emphasis on the “wait” before changing their strategy.

“The big uncertainty about going to war is gone,” said Michael Steed, a managing director with Paladin Capital. “Now the uncertainty centers on the outcome… and in times of uncertainty private equity serves as the buffer between the inability of public markets to provide capital and the needs of the companies that are in search of capital. There will be a pause, but at the end of the day, private equity will play a significant role in keeping the economy stable.”

That said, most private equity pros expect the war to create some tentativeness. Jeff Rosenkranz, managing director and co-head of U.S. Bancorp Piper Jaffray’s Middle-Market M&A Group, said, “As long as there is still uncertainty about a conclusion [of the war], the private equity community will be very hesitant.” He added, “The cloud will lift with the end of the conflict, and we expect deal flow to start to accelerate at that point.”

That scenario would be in line with what happened in 1991, a year that at first glance appears to provide a fairly representative model for what we might expect given our current circumstances: a slumping economy, a war with Iraq and a president named George Bush. In 1991, which saw 46 days of conflict, from Jan. 17 to March 3, LBO shops appeared to have hunkered down during the fighting, only to emerge at its conclusion with a flurry of deals. In February 1991, there were only 18 buyout-related deals completed, while in March, which essentially began with the war’s finale, LBO firms completed a total of 61 buyout-related deals, according to VentureXpert. The 61 deals completed that March easily surpassed every other month that year.

However, there are still some very notable differences between 1991 and today, which makes forecasting LBO activity very difficult. First, in 1991, the U.S. economy was still in recession, while today the recession has at least passed, despite the looming threat of even more economic problems. And even as the economy is expected to show some growth, corporate governance issues continue to hamper expansion. Also, the combination of hefty tax breaks and a flurry of interest rate cuts from the past two years has reduced the government and Federal Reserve’s abilities to stimulate the economy either during or following the war. In 1991, the interest rate stood at 6.75%, giving the Federal Reserve room to make 12 cuts over the next two years and eventually get the economy back on its feet. Currently the Federal funds rate sits at 1.25%, representing a four-decade low.

Still, most LBO players agree that something will need to happen to fuel growth. “We’ve got to get these markets liquid again,” Steed said. “We’ve got low interest rates, which makes you think money would be available, but it’s not happening.”

Foreign anti-war sentiment

Another notable distinction between this Gulf War and the last is that the U.S. does not have the worldwide backing that accompanied the 1991 battle. This has led to protests around the world, most of which appear to be tinged with an anti-American sentiment. What does this mean for U.S. buyout players abroad? Not much, according to Will Schmidt, a managing director in Advent International’s London office, who believes deals will boil down to “price and procedure” whether the sponsor is American or not. He also noted that a lot still depends on how sophisticated the buyout shops are, and pointed out that most of the bigger shops staff themselves with professionals from Europe and Asia. But this, he notes, has always been a factor when dealing overseas.

Another major difference between 1991 and today are the primary goals of the conflict and, thus, the type of war that is being fought. In the first Gulf War, the U.S. was liberating Kuwait from Iraq’s incursion, and the war was over as soon as Iraq withdrew. This time around, the U.S. is on a mission to oust Saddam Hussein, an objective that could require a dangerous battle inside of Baghdad. Also, the U.S. is staging this battle as part of a larger war against terrorism, and even if the U.S. is successful in ousting Saddam, fear of terrorist reprisals could blanket the economy for some time after the war’s conclusion.

This is not to say that private equity firms won’t make the most of whatever situation they are given. The best evidence of this is seen by how the buyout shops reacted to the terrorist attacks of Sept. 11, which, despite its devastating effects, still opened the door for new investment. Last year, Castle Harlan was one of those firms that was able cash in on the country’s move to beef up security in the wake of the terrorist attacks, and realized a 120% annual IRR with the sale of explosive-detection company Ion Track.

With this latest Iraqi war there are some firms with investments that are actually benefiting from the conflict. Falconhead Capital’s acquisition of Maritime Telecommunications Network (MTN) in February is among those reaping rewards, as the portfolio company has taken on the task of providing NBC the ability to broadcast from the front lines with MTN’s truck-based mobile satellite transmission platform.

A source said the contract totaled less than $1 million, but noted that it is a nonexclusive agreement and there is the possibility that other networks will follow. The satellite transmission platform was built from start to finish in 45 days, the source added.

The war will also open up opportunities from a valuation standpoint, especially for certain sectors such as the airlines and travel industry. General uneasiness about travel, derived from the threat of terrorism coupled with rising fuel costs associated with war, means that many in the travel industry will be looking for some kind of assistance to help cope with the problem. The airline industry has already asked the government for $13 billion in new relief, which may or may not be coming, and either way, it would not surprise most buyout pros if the sector turned to private equity for additional capital. Before the war even started, Texas Pacific Group had been rumored to be sniffing out a bid to gain control of United Airways, which is currently under bankruptcy protection.

There are also those that believe this war could be the end of the defense sector’s strong run. Stewart Kohl, managing general partner at The Riverside Company, said, “Defense has had a very good run. Still, there’s a question about how long that will go on. There are a lot of other needs right now. States are going bankrupt, Medicare is facing challenges, [defense spending] could decline post-war.”

Battle For Financing?

Even if buyout shops want to do deals in these times, there’s always the question of whether financing will be available to get deals done. Bob Stefanowski, a managing director at GE’s Structured Finance Group, believes it will be accessible. “The uncertainty was holding people back. Now [that the war has begun], we’re moving forward one way or another. The money on the asset side has been there for a while and on the cash flow side, the situation should start to improve,” he said. “It’s been a tough winter. Now that the end is in sight, people are saying, Let’s get back to business.'”

That’s good news for private equity players, who, for the most part, have not shown any desire to pull back. In fact, some in the industry may even accelerate their investment pace given the environment. Kohl said, “We find that the toughest time to do deals is generally the best time to do them. In the deals that were done between 1998 and 2000 [when the economy appeared to be at its strongest], even the best firms only broke even. Deals done in the early 1990s, when we had the first Gulf War, yielded fantastic returns.”

Still, some do not see the war as necessarily having a significant bearing on what happens in private equity. James E. Crawford, III, a managing partner at Frontenac, said, “In my own judgement, a long, tough war could continue to stall the economy. That could be helpful for valuations but hurt portfolios… I expect the war to be intense and short, which would not have much impact [on private equity].”