Flickers of Promise For the LBO Dealmaker: A veteran leveraged deal professional points to sometimes subtle signs that the industry’s long decline is nearing bottom.

Without question, the buyout industry has been suffering. Symptoms of ill health in this popular asset class started to become visible about 24 months ago when actual rates of return on invested capital began to dissipate in early 2000. By mid-2000, the broader private equity boom began to decline of its own weight, a downdraft further accelerated by monetary policy, credit rationing by banks, higher labor costs, a faltering stock market, higher energy prices, and a collapse of the high-yield debt market. The numbers track the LBO market’s decline. For all of 2001, according to Thomson Financial’s Mergers & Acquisitions Database, only 159 leveraged transactions, valued at $18.6 billion, were completed, down from an already depressed 307 deals with an aggregate value of $51.5 billion the year before. Both totals dropped sharply from the recent peak of 386 deals with a value of $62 billion in 1999. Performance data from the buyout community is turning downward and will worsen as accounting rules necessitate write-downs of goodwill and buyout shops reconcile themselves to incurable portfolio problems in the form of troubled businesses that they own. Many of the country’s leading buyout firms disclose, sometimes proudly, that they haven’t done a deal in 12 to 18 months, leaving large uncommitted amounts in equity funds. That may be good for limited partners, but profit margins for general partners have shrunk under the combined effects of less dealmaking, diminished asset values, and fewer realizations. Capital deployed from buyout funds over the past two-and-a-half years and current economic hardships badgering investments made in prior time frames will result in substandard LBO returns for the next few years. After years of raising record amounts of money for equity investment, fund-raising hardships are expected to increase, which will result in the disappearance or consolidation of marginal buyout platforms, in the lower and middle marketplaces especially. Nevertheless, amid all of these gloomy signs, there are some indications that the bottom of the market’s lengthy decline may be near. Why Is It Happening? Dealmaking is increasingly scarce because of a widening spread between seller expectations and valuations that make economic sense to buyout investors. Declining stock prices discourage public companies from using stock as currency for acquisitions. Fewer quality investment products are coming to market, and once-secure exit strategies are in disarray. The economy is weaker than anytime since 1982. Of particular concern to buyout investors is that the commercial default rate has approached 4%, consistent with conditions at the peak of the last recession. More significantly, loan defaults totaled about $100 billion in 2001, more than double the prior year’s total and nearly four times the $23.6 billion in defaults at the peak of the last recession. A disproportionate number of these “busts” featured leveraged capitalizations. The manufacturing sector has been in a deep recession for 24 months and other segments of the economy are following suit, most notably the technology, telecommunications, transportation, and hospitality industries. Credit rationing by banks, at the behest of the Comptroller of the Currency, is having a devastating effect on an industry whose lifeblood is rooted in liquidity. We have witnessed an extraordinary consolidation of 50 major U.S. banks, many of them leading lenders into leveraged deals, to just seven institutions over the last 10 years. All of this is adding up to a credit crunch of record proportions for buyout investors as they unsuccessfully grasp for leverage geometry – a historically crucial ingredient for maximizing returns and mitigating risk for investors. The sharpest drop in industrial output in 20 years has occurred because the liquidity squeeze has forced companies to shrink inventories, lay off workers, and extend accounts payable. Traditional sources of equity are defecting from the buyout landscape because of an uncertain economic outlook, allocation imbalances wrought by a depressed stock market, and the rise of safe-harbor instincts from the uncertainties triggered by the attack on the World Trade Center last September 11. A deep high-yield market is but a wistful memory. Taken as a whole, these factors add up to an LBO nightmare. Today’s Private Equity Challenge Buyout investing is a less certain and more complex investment discipline than ever before because franchise profiles over a broad front are inherently less durable. Moreover, investment managers and banks fret over “earnings visibility.” What, indeed, are investors to do as they fret over what level of earnings to apply to anemic credit multiples? Punishing waves of disintermediation continue to roil over markets once considered secure because of breakneck technological change and global competition. Product cycles and pricing power are hard to measure, placing a premium on portfolio managers with extensive experience in operating businesses. We believe that the buyout market is coming back. To say that it is coming back is no mark of genius, because the market always recovers. Calling the timing of the comeback is another story. There are mountains of “dry powder” out there – in the form of uncommitted equity funds – ready to be sprung as valuations continue to decline and sellers appear more motivated. The missing piece of the puzzle is a better lending market, and the party must wait for that to develop. Timing the Bottom What will cause the senior debt market to open up? Encouragement from the Comptroller of the Currency and Federal Reserve Chairman Alan Greenspan wouldn’t hurt. Watch for the revival of the high-yield market and more particularly the prosperity of high-yield mutual funds as investors recognize that the economy is near bottom and that high-yield credit is less likely to jeopardize their principal. When this happens, investors will hand over considerable amounts of capital to high-yield investment managers, which in turn will arouse the competitive juices of senior lenders. Watch carefully through the pipeline the revival of B-rated credits. This development would foretell a shift in risk tolerance that would classically result in a competitive response from senior lenders. However, at the moment, the average senior secured credit is trading on the secondary market for 96 cents on the dollar. Why then buy a new credit for 4 cents more? Investors should care less about timing a bottom just right than about avoiding the wrong timing. With that in mind, here are of the signals that suggest that the bottom may be near: * Senior lending practices have conclusively migrated from a cash flow to an asset-based basis as banks lose faith in earnings projections: a classic inflection point signaling the base of a trough. * Companies looking to sell themselves are coming to buyout players directly more often than any time in the last two-and-a-half years. Reluctant sellers once content to wait out the return of a surging stock market to support higher valuations for their businesses are concluding that lower prices may be around for a long time. As a consequence, seller psychology is changing. * Buyout players are finding more value in growth markets, which comes as a result of company needs for capital to address various liquidity objectives that cannot wait any longer. Most often, this is a sure sign of an emerging buyer’s market. * Earnings visibility should improve along with the economy. In this regard it is hard to ignore the positive effects of a massive inventory liquidation that occurred throughout 2001. Also hard to ignore are the tightest consumer sentiment figures in 12 months and a dramatic decline in new unemployment claims in December and January. Rate cuts and massive government spending initiatives in 2001 are about to leave their mark. * With the approach of mid-term elections, Republicans and Democrats are scrambling to ensure and seize credit for a revived economy. That should be translated into economic stimulus actions. An increasing number of anecdotal factors also have begun to warrant attention. There is more talk than ever about creative deal structures. Usually just about the time when dealmakers are taking bows for creative deal structures, they’re not needed any longer. Furthermore, it has been our experience that the best deals are made in the worst of times, or just before an upturn. Finally, consider the “Porsche factor.” Four times over the past month we have heard of cases where a 30-something CEO-entrepreneur, usually leading a mid- to late-stage venture or development deal, has finally resigned himself or herself to a sale of the Porsche. Experience tells us that the Porsche is usually the last to go and that rising fortunes in private equity are never far behind. Alas, on this final cornerstone of statistical probability, we are betting on a buyout recovery sometime soon.