Mid-Market LBO Firms Slate Increases In Acquisitions and Portfolio Sales

While most players in the mergers and acquisitions market remain on the sidelines, LBO firms specializing in mid-sized transactions are targeting an aggressive acceleration of dealmaking – on both the buy and sell sides. Plans to step up activity are aimed mostly at putting billions in unused money to work, rather than in response to expectations of improved tones in the economy and the capital markets. But many firms are acknowledging that they probably will pay a price for stirring while others sit idle by cutting expectations on their returns and anticipating that they will have to inject more equity in the buyout structures to get deals done. The projected trends for 2003 emerged from a report by Robert W. Baird & Co. that compiled key data in a survey of private equity firms focusing on mid-sized transactions. Baird drew responses from 151 firms of 390 contacted, with the respondents collectively managing $84 billion in capital and owning a total of 2,300 portfolio companies. Pressure to move exists on the buy side, Baird reported, because the average responding shop committed only 38% of its total funds to investments through 2002, while on the sell side, “we calculated the average investment age of the portfolio companies to be just over three years, indicating an increased backlog of pending exits.” This should translate into a pickup in acquisitions and other investments of better than 50% from 2002 levels in 2003 and a higher level of exits, mostly through straight sales. But in conceding that 2003 is not the most favorable time to be buying and selling, a significant number of the responding firms said they likely must trim their sails on transactional profits. A quarter of them said they anticipated “slightly lower returns” in 2003. Those willing to deliver numbers said the returns probably would be in the 20% to 30% range compared with historical returns of better than 30%. “As a result, many firms are…now willing to commit higher levels of equity to complete quality transactions,” the Baird report said. “We expect reduced return criteria to result in increased transaction activity and greater competition among the private equity firms.” The report did not go into deal pricing expectations, but the need to move money and the prospect of some contested bidding could lift long-depressed offering prices and surface a fair number of private companies whose owners have balked at selling on the cheap. A paucity of quality targets on the block has been among the primary depressants in the tepid deal flow of the last two years. Based on the responses, Baird calculates deals on the buy side should jump more than 53% from 2002 levels. Respondents reported executing 419 transactions last year, or an average of 3.2 per firm. When their projections of 2003 activity were totaled, they came to 642 deals, or an average of 4.8 per firm. About two-thirds of the transactions would be aimed at new platform investments and a third for add-on acquisitions, Baird determined. On the sell side, two of five respondent firms reported that they had to put the brakes on planned exits because of market conditions in 2002. But private equity players are hoping that they will move more properties this year. On the basis of the responses, Baird calculated that the LBO firms planned to unload 709 businesses over the next three years, or slightly less than a third of the total companies owned. About a third could come to market in 2003. Respondents said they hoped to sell off 89 companies in the first half and another 138 in a six-to-12 month time frame. A whopping three-quarters of the respondents fingered a sale or merger as the preferred exit route with 14% looking for recaps and only 11% indicating they could go for IPOs. Going public has been a low priority in the last two years because of the depressed IPO market and an especially poor reception for mid-cap and low-cap stocks. “With the current state of the equity markets, most portfolio companies are not large enough or in the right sectors to attract significant investor through an IPO, leaving a sale/merger as the most viable option,” the report stated. Although the report indicated that pricing and other market conditions did the most to block exits last year, Baird acknowledged that a good many portfolio companies were too troubled to take to market and required rehabilitation. It reported that a total of 114 firms said that a total of 279 of their properties needed financial restructuring in 2003, or roughly 15% of total holdings. Restructuring plays were projected to slip in 2003 to a total of 128 portfolio companies. “The current market environment led many firms to hold off exiting their investments in 2002, hoping for an improvement in both valuation multiples and the financial performance of their portfolio companies,” the report said. “This has led to a growing backlog of portfolio companies that must eventually come to market. We calculated the median age of a portfolio company to be about three years, indicating that many portfolios are becoming mature. As the holding period of the companies in the portfolio increases, private equity firms will be looking to realize portfolio returns, especially as they plan future fund raising.” In drawing their buy-sell blueprints for 2003, mid-market private equity firms will be acting irrespective of the general economy and financing markets. Three out of four respondents expect no change in the currently sluggish to flagging economy throughout the year – with only 15% looking for and upturn. A mere 6% think that the financing environment will improve in the first half, although nearly half – 48% – are banking on a better tone in the second half. That may have played a role in the finding that there has been some change in the investment mix. About a quarter of the firms said they have shifted focus, with more emphasis on business and consumer services, health care and medical devices, basic manufacturing, financial services, and distribution and less on telecommunications and software. Nine of 10 respondents said they would concentrate 2002 investments on LBOs with seven of eight willing to consider recaps, nearly four in five taking public companies private, and seven in 10 industry roll-ups. PIPE (private investment for public equity) deals and turnarounds had the lowest levels of support. 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