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Private Equity and the State of Leveraged M&A

Posted on July 29, 2009

The market for private companies depends on two primary sources of demand, strategic buyers and private equity.  We’ve reported that Focus’s M&A practice has remained strong notwithstanding the recession with six closings year to date.  These deals have all been strategic with our firm representing both buyers and sellers.  Only one of the transactions could be considered a “distressed” deal.  From our vantage point, it appears that in the middle market the strategic buyers neither paid up excessively in the boom, nor have they slashed their valuations unreasonably in the bust.  If the acquisition makes strategic sense, these buyers appear willing to pay a fair multiple that relates more to the impact of the deal on their earnings projections than the state of the financial markets.

Financial deals engineered by private equity firms are another matter altogether.

Total Private Equity Deal Flow


private-equity-deal-flow

Source: PitchBook Data, Inc. (www.pitchbook.com)

According to PitchBook, from the peak in Q4 2007 to Q2 2009, dollar volume of PE deals (including buyouts, growth financings and other) declined almost 96% from $177 billion to $11 billion.  The number of deals declined almost 75% from a peak of 702 in Q2 2007 to 174 in Q2 2009.  PE buyout deals declined even further than overall PE deals, from $168.8 billion in Q4 2007 to $2.6 billion in Q2 2009, a 98.5% decline.   The number of reported PE buyout deals declined almost 80% from 570 in Q2 2007 to 116 in Q2 2009.  This confirms our observation that middle market PEGs responsible for smaller transactions have remained more active than their large deal brethren, but that everyone in the industry has been hit hard.

While there are a number of reasons for the sharp decline in PE activity, most observers agree that the primary issue is the lack of available leverage to fund transactions.  In the last issue we reported on the almost complete collapse of leveraged lending, the primary source of financing for the megadeals.  Reuters reported that middle market loan volume was down 63% from Q1 2008 to Q1 2009.  Lending for new M&A deals was clearly down much further.   In the UK it was recently reported that middle market M&A deals were at their lowest point since 1995 and that overall M&A was at its lowest point since Q4 1993.   Reflecting the decline in leverage, PE firms have reportedly reduced the earnings multiples they are willing to offer.  Lower prices have caused many sellers to pull back from the market.  As a result a greater portion of the PE deal activity that has occurred involves financially distressed sellers, including additional funding for more than a few PE portfolio companies short of capital.

Lack of equity capital is not the driver of reduced PE buyout activity.  PitchBook recently reported that the private equity overhang (I.e. committed, but uninvested PE capital) hit a record $400 billion at the end of April 2009.

Private Equity Overhang

private-equity-overhang

Source: PitchBook Data, Inc. (www.pitchbook.com)

While rumors persist that some PE investors have reneged on capital commitments, this appears to be a minor factor to date and PE firms continue to receive new commitments ($46 billion YTD through April 2009).  This tremendous overhang would seem to dictate that, at some point, the floodgates will reopen, leading to a dramatic recovery in the M&A market.  Unfortunately that date could be some time off.  PE funds typically have expected investment horizons of as many as seven to ten years so many fund managers have the luxury of waiting for better purchase multiples, higher leverage or both.  For now we expect to see continued moderate levels of PE activity in the middle market and now quick return of the megadeals.  For now the relative strength is with the strategic buyers and there is no reason to think this will change soon.

Secondary Loan Markets On a Tear – Is M&A Rebirth Far Behind?

Posted on April 23, 2009

Since the collapse of the syndicated loan markets in August 2007, the private equity M&A market has gone from red hot to stone cold at the high end and luke warm in the middle market. The primary cause of this collapse is not lack of equity; at the beginning of the year PE firms had close to $200 Billion of dry powder. The issue holding back the M&A market worldwide has been the lack of leverage for new deals.

The M&A bubble of 2005-2007 was driven in great part by an explosion of new funding sources that entered the leveraged lending market, leading to an unprecedented narrowing of lending spreads. At the peak, leveraged loans were being written at spreads as much as 300 basis points narrower than historical norms. Funding sources included hedge funds, special purpose entities created by the banks, collateralized loan obligations (CLOs), institutional investors and various international purchasers.

From the market crack in August 2007 through August 2008, this market traded at a discount of up to 10% of principal, reflecting a partial return to normality in terms of risk based loan spreads. During this period it became increasingly difficult for lenders to syndicate new deals. In September 2008, coinciding with the collapse of Lehman Brothers, this market went into freefall with a basket of the largest leveraged loans trading below 65% of principal by late 2008. The market for new syndications, particularly the multibillion dollar deals that had been so prevalent, ground to a virtual halt.

leveraged-loans

Source Churchill Financial - On the Left; S&P LCD Index

At the beginning of this year, the leveraged loan market priced in not only a correction of the previous mispricing of risk, but the assumption that battle horns were blowing in the Valley of Armageddon. After rising from 63.5 to 80.6 in the last four months, the LCD Index now reflects normalization of spreads plus a fifty year flood, a substantial improvement, but far from Nirvana. The market collapse in fall 2008 had far more to do with the deleveraging of the hedge funds and special purpose entities than it did with a considered pricing of risk. A cry of “give me a bid, any bid” could be heard across the land. As the deleveraging has run its course, inventories have declined and prices have recovered.

In a thoughtful piece in Tuesday’s Wall Street Journal, Michael Milken described past manic swings in the leverage levels of America’s corporate balance sheets. He pointed out that every cycle of overleveraging has been followed by a period of recapitalization, through debt for equity exchanges, repurchases of discounted debt and new equity offerings, which restores corporate balance sheets and provides the foundation for a renewal of new investment and growth. The current rebound in leveraged loan pricing may indicate that this process is now underway in the current cycle.

So long as existing senior debt was trading to yield potential returns approaching 20% per annum, those lenders with capital remaining had little incentive to provide new debt at acceptable spreads. With that competition for investment dollars winding down, new loans will become increasingly available, though still at spreads far in excess of those available at the peak of the boom. While we are a long way from a return to the frothy M&A market of mid-decade, it’s reasonable to expect a return of the financial buyers to the marketplace and a far more active M&A market for the balance of the year than we have seen over the past six months.