Anyone know how deals will be made without the benefit of a liquid LBO / PE market? It would seem that with a downturn in the economy, there will be good opportunities for mergers/acquisitions — but how can this happen without the aid of the credit markets?
Mezz funds have money available. They just charge an arm and a leg for it now.
No credit + way lower valuation multiples = no deals. Or should I say, much fewer deals. B
Returns will come through paying low valuations, as opposed to using leverage for the forseeable future. We’re seeing deals that would have gone for 7.0x to 8.5x 18 months ago, go for 4.5x to 6.0x now because buyers just cannot get the same level of debt. Not only are valuations changing but structures are changing too - and not in the seller’s favour. Buyers are demanding more and higher earn-outs and vendor take back notes. Very crappy time to be a seller right now. Smart strategic buyers with cash know the ball is in their court. PE LBOs are dead for now. You may see the odd tuck in acquisition onto an existing platform investment, but any deals of significance will involve strategic buyers and likely involve paper (e.g. Pfizer / Wyeth), a luxury PE buyers don’t have. Smart PEs are spending time looking after the eggs in their nest right now - cutting costs, minimizing /avoiding defaults wherever they can, and trying to calm the nerves of their LPs.
we’re lucky since we have a decent cash reserve. so we’re picking up small, regional competitors who haven’t been able to make it through this environment. we offer them a low valuation, but since we’re able to pay in cash, it works out well for both parties - we eliminate a competitor and acquire their cash flows, while they’re able to feed their families. it’s a win-win
"but any deals of significance will involve strategic buyers and likely involve paper (e.g. Pfizer / Wyeth), a luxury PE buyers don’t have. " Hey Bhill - what do you mean a paper deal? As in, the seller carrying back?
seller takes back shares of the buyer.
Bhill, I dont understand on the comparative PE between 18 months ago and now. Would you kind enough to elaborate more on the circumstances on the technical side?
bhill020 Wrote: ------------------------------------------------------- > Returns will come through paying low valuations, > as opposed to using leverage for the forseeable > future. We’re seeing deals that would have gone > for 7.0x to 8.5x 18 months ago, go for 4.5x to > 6.0x now because buyers just cannot get the same > level of debt. Not only are valuations changing > but structures are changing too - and not in the > seller’s favour. Buyers are demanding more and > higher earn-outs and vendor take back notes. Very > crappy time to be a seller right now. Smart > strategic buyers with cash know the ball is in > their court. I pretty much agree with bhill020’s assessment. Good companies are still going for sizable multiples though – i.e. upward of 7.5x LTM EBITDA – but a lot of the middle-of-the-road companies have seen their multiples come down a lot. Part of it has to do with the markets going south, but the other part of it has to do with credit just being very expensive right now as bhill020 pointed out. > > PE LBOs are dead for now. You may see the odd > tuck in acquisition onto an existing platform > investment, but any deals of significance will > involve strategic buyers and likely involve paper > (e.g. Pfizer / Wyeth), a luxury PE buyers don’t > have. It’s much harder to get LBO’s done, simply because there’s just not much “L” in “LBO” anymore. We have completed a couple deals recently though – one of them was a platform and the other was an add-on – and the capital structure was pretty close to 50% debt/50% equity. The terms of the senior debt were pretty favorable and there was one turn of sub debt. I think on average, we’re looking at 2.75-3.0x LTM EBITDA of total debt on most deals these days, which means that in order to get a deal done, you’d be looking to invest at least 50% in equity. > > Smart PEs are spending time looking after the eggs > in their nest right now - cutting costs, > minimizing /avoiding defaults wherever they can, > and trying to calm the nerves of their LPs. Definitely…since the deal environment overall isn’t that good, most firms are just focused on managing their portfolio companies so that their fund performance doesn’t totally implode. BTW, what type of private equity do you work in? I’m at a large middle-market buyout shop in the United States.
keelim Wrote: ------------------------------------------------------- > Bhill, > > I dont understand on the comparative PE between 18 > months ago and now. Would you kind enough to > elaborate more on the circumstances on the > technical side? The “technical side”? What do you mean? To answer the rest of your question, something called the “credit crunch” happened, which effectively caused two major events that sent major shockwaves through the buyout market: (1) credit became utterly expensive, and leverage, which was once cheap, has become expensive or simply unattainable; and (2) because hardly anyone has credit or cash, there just aren’t that many parties out there that have the money to buy assets – whether it’s companies, stocks, or whatever – causing all markets around the world to go into a tailspin. There was a time between 2004 and early 2007 when credit was way too cheap and LBO and M&A activity were simply too exuberant – some people at the time thought this activity would be unsustainable as housing surely couldn’t continue to appreciate in value at the same rate it had been going. Well, those people were among the minority, but they turned out to be correct. Not trying to be flippant or anything, but this is sort of a big deal – the kind of thing that’s been in the news every day for the last 18 months
numi - thanks for doing a far better job of explaining than I would have! keelim - i’m not sure how familiar you are with the typical deal structure of an LBO, but essentially PEs can only use a limited amount of equity to finance a deal (see below), otherwise the IRR will be too low. The more equity used, the more the IRR is ground down. In an LBO, a substantial portion of the purchase price is financed with debt. This debt becomes debt of the target company and is added to its balance sheet and repaid using the company’s free cash flow over 3 to 5 years. Once the debt is substantially repaid (or a recapitalization has taken place which numi can explain!), the PE sells the business. A simplified example, using a target company with zero net debt and $5M EBITDA…lets say comps show a median EV/EBITDA of 5.0x is as follows: Enterprise Value = 5.0x $5M = $25M Scenario 1 - Purchase price financed with 100% equity. - Equity IN: $25M (today) - Company is sold 5 years later for 6.0x EBITDA and its EBITDA has increased to $7.5M - Equity OUT: $45M (after 5 years) - IRR = 12.5% Scenario 2 - Purchase price financed using $10M equity and $15M (or 3.0x EBITDA) of debt, and assume debt is fully repaid over the 5 years using FCF of the company: - Enterprise Value = $25M - Less: Debt ($15M) - Equity IN: $10M (today) - same sale price assumed - Equity OUT: $45M (after 5 years) - IRR = 35% Credit markets right now will not provide PEs with the debt they need to get the IRR up high enough, thus negatively impacting potential returns from using leverage. This gets back to low valuations that we are beginning to see. If you can acquire at a low enough valuation and then sell for a high valuation later, you can still achieve a healthy IRR. For example, if the above company was acquired for only 4.0x using just one turn of debt ($5M) and $15M equity, then later sold for the $45M. The IRR would be a reasonable 25%. Hope that helps rather than confuses you. Feel free to correct any technical errors numi.
bhill020, that’s a good basic explanation of how LBO’s work. i don’t have much to add, except that another reason why lenders aren’t willing to provide PE’s with as much credit is not only because credit is in tight supply, but also because they too need higher returns in order to justify the risk in this uncertain market. BTW just curious – what field are you in? banking, PE, accounting?
Mid-market, mostly sell side M&A, specifically the corporate finance group of a Big Four. Lately the deals have been more distressed / restructuring in nature. Since the downturn, we’re working more closely with our restructuring practice…it’s been nice to have that option and I don’t mind the distressed files because they move a lot faster. Are you in mid-market PE numi? In the U.S.? (I’m in Canada)
sorry just saw the post above…large mid-market U.S. buyout. Are you guys still actively looking at opportunities? Have you seen the volume of opportunities come across your desk decrease significantly from 12 to 18 months ago?
numi, bhill any thought to the health of the pe portfolio companies? one aspect of the credit crunch that we have yet to fully see is the corporate defaults. i think this exists whether term loans, bank debt was used to finance and public/junk bond debt as well.
Sorry about the slow response, folks. bhill020, deal flow is definitely down compared to a year ago, but we are still seeing a fair number of opportunities. Like most PE firms, we’re also trying to manage our existing portfolio companies, but there are still deals to be had out there. Valuations for mediocre companies have come down quite a bit, but good companies are still going for pretty high multiples. I suspect it’s because there is a scarcity of good companies that are being pitched right now, and there are a lot of PE firms that are sitting on cash (or “dry powder” as some would say). RIGWDL3, PE portfolio companies are as exposed to the economy as regular, run of the mill companies. The key right now is to manage fixed costs, capital expenditures and operating expenses. You hope that the companies don’t end up breaking covenants, but that’s been a possibility as well as a reality for certain companies. There are a number of PE firms that have had layoffs so far – I think most of them are publicly traded (such as Allied, American Capital, Carlyle, etc. ) as they may need to “send a message” to their shareholders about managing their own expenses. But our compensation was definitely under some pressure last year because of fund performance which unfortunately resulted in bonuses being down. The outlook for 2009 is pretty humbling as well, but valuations for companies should go down further and we’re looking for deal flow to perhaps turn a corner in the latter half of 2009. Hope that helps…
bhill and numi - with all the money that PE funds have raised but not yet deployed, why cant they take advantage of distressed sellers - pay in cash (75 cash/25 debt) and then a year down the road do a recapitalization (25 cash/75 debt). Are they thinking that the credit markets would be better AND valuations will stay low and they’ll be able to scoop some interesting companies? Is that a realistic scenario? Is that how they do analysis of WHEN to buy?
bsivia, that’s a good question. I’d be curious to hear your thoughts as well as anyone else’s, but here’s my take on things. First of all, while some PE firms may be sitting on a fair amount of cash, most of them have had trouble raising new funds. Again, cash is king in this market; even though the firms that have it want to put it to work (as we do), they’re not just going to shoot from the hip. You never know when the next good deal is going to come around, and you certainly don’t want to put all your cash into a single deal because you never know when you will have new cash coming in. That’s why you don’t see companies doing 75% equity/25% debt deals – the deal environment isn’t THAT bad yet, and even though PE firms want to get deals done, they’re not going to totally change their investment or leverage approach – at least not just yet. To your second point about the recapitalization – while that is a real possibility, the current state of the market is just way too uncertain. I understand that private equity is all about taking on leverage and risks in an uncertain environment, but the risks are always calculated. True, maybe things will improve “down the line” as you suggest, but credit probably won’t be that easy for the foreseeable future, and because of that, nobody really wants to take a chance on putting in so much equity into a deal upfront because there is a very real possibility that the returns will be diluted. Plus, there are still deals in the market that can be done with fairly acceptable leverage (like 50-60%). Some PE firms may look at deals that are considered “less sexy,” but might still be willing to get them done, simply because because valuations for mediocre companies have indeed gone down a lot, and it’s easier to take chances on those since your downside is more limited as a result of the low multiple you’re paying to acquire it. Hope that answers your question… BTW, for those of you that are further curious about the matter of deal valuation (be it M&A, LBO, or whatever, there is a good site called The Private Equiteer (www.theprivateequiteer.com). It is set up in a blog format but provides a primer about relevant and topical issues in private equity. As for PE firms that are trying to exit their investments in a market where valuations are declining, here are some “strategies” (excerpted from the website). These are all considerations that we look at when we think about buying a company, and the article below provides a great summary of them: "It’s not exactly news that multiples are heading south. Data from Preqin and many other sources showed 2007/2008 purchase multiples being north of 8x, often with debt representing 5x. Now however, purchase multiples are more likely to be around 5x, with debt representing about 3x (if you’re lucky). This is a major issue for funds that made purchases at 8x, because they need to use regular value creation tools (heaven forbid), such as sales growth and cost cutting, to keep value from plummeting. But, that’s another story for another day; I would rather talk about what drives valuation multiples. This can refer to multiples used in fund valuations, deal negotiations, or for whatever purpose. So, the following list describes the individual drivers for proposed purchase multiples of businesses: * Business size: a larger business has a larger market share (usually), more stability (mostly) and is more attractive to buyers (generally). Therefore, a larger business demands a premium. * Stability: revenue and earnings stability drives confidence in forecasts and more bankable forecasts demand a premium. Unstable businesses are riskier and require a higher required return, hence a lower multiple. * Diversification: a business with a diversified product range, customer base and supplier list is less risky. These all affect earnings stability (see above) and hence, influence the multiple. * Capex: this is often forgotten when just looking at EBITDA, which is why some people use multiples of EBIT (using depreciation as a proxy for capex) or good ol’ FCF (free cash flow, which accounts directly for capex). Capex represents a large portion of costs that don’t hit the P&L (until they’re depreciated), so it’s important to consider capex in your valuation. Reduce EBITDA multiples for high capex businesses. * Intellectual property: in private equity, we tend not to pay extra for IP because it is often needed to produce the cash flow. However, we may pay a higher multiple because proprietary IP represents greater differentiation, more stability, higher barriers to imitation and less risk. * Growth: revenue growth is important to private equity because it’s one of the main tools to achieve value creation. So a business with higher (and realistic) growth forecasts demands a higher multiple. However, it’s important to be pessimistic about management forecasts because 90% of the time they don’t eventuate. * Synergies: a buyer that has the potential to realise synergistic benefits from an acquisition can generally pay a higher multiple because the acquisition represents a greater value to them. This is one of those drivers that means the ideal multiple for me can be different to the one for you. * Debt capacity: more debt adds more risk (insolvency, default, etc) to the business, but it also amplifies returns and reduces the overall cost of capital. The ability to add more debt commands a premium. * Deal terms: a purchase multiple can be manipulated by the terms of the deal. If the deal is 100% cash up-front, the multiple will be lower than if some of the purchase price is contingent on future earnings. Be very cognisant of the time value of money and that contingent payments have less value if paid later. So, if $100m is paid today plus $100m is paid in 5 years, the purchase price isn’t $200m. It could be more like $130m, depending on your discount rate. A deal can be manipulated to show a much higher multiple on paper. * Comps: although comparable transactions are the most common drivers of multiples, they are often the least appropriate. Even if exactly the same business was sold at exactly the same time, synergies and other buyer-related drivers (deal terms, debt capacity, etc.) can affect the real value of the business. But in saying that, you’ll almost never see the same business for sale at the same time, so many other variables are introduced. So it’s best to be more objective and concentrate on the more fundamental drivers that I’ve listed above. "
bhill and numi, Thanks on the example and clarification. Correct my understanding on LBO if I am wrong. Normally in a LBO exercise, we have to know the transaction assumptions. These confidential information is held by the top managements of the deal (the purchase price and how the deal will be financed). With these information (top management will not reveal the figures but required sensitivity analysis on it) the merchant bankers will be required to set up a table of Uses and Sources of Funds. Next we procees with the target company historical balance sheet. The merchant bankers are required to build a proforma balance sheet that has incorporated the new capital structure (debt, equity, goodwill, and capitalized financing fees if any). With this proforma BS, and certain projected assumptions of the business model, the bankers will develop (let say 5 years) an integrated cashflow model and financial statements. With the functioning model ready, we can make assumptions about the PE firm’s exit strategy. Of course the implied EBITDA multiple now will be different to the multiple when the company was purchased. After the selling price is determined, IRR is next. This is my understanding of a LBO analysis. My questions are: 1) Why in the calculation of IRR, leveraging increases it? Is the free cash flow to firm being used to calculate IRR or free cash flow to equity? 2)As we are all aware of, cost of capital involve the weighted average of equity and debt financing risk. Debt being net of tax. Does this mean financing more with debt we will have a lower cost of capital? (Cost of equity is generally higher than cost of debt, but with the market condition is it otherwise?) 3) I have some confusion on EV/EBITDA multiple. How do we justify the multiple in an event of LBO. From precedent transaction or comparable company analysis? Is the purchase and selling price base solely on EV/EBITDA multiple? 4) In the event that PE does not want to sell the investment, but managing its portfolio, will the dividend/profit received from the firm become more beneficial? This is an arguement because a good target LBO must have a minimum criteria of steady cashflows (apart from limited business risk, strong management, high asset base n etc). Since it was a good investment initially, why dispose it? Someone please clarify 
thx
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