Private Equity Buyers Hustle To Move Money in a Slightly Warmer Deals Climate

Tides are turning modestly in favor of LBO sponsors who still are managing billions in cash that need to be committed to acquisitions. Lenders are loosening, the high-yield debt sector is strong, and more properties are reaching the market as sellers get used to prevailing pricing currents. But innovative structures, staking out positions of strength, and paying full prices are required to navigate the incessantly choppy marketplace. M&A: Acquisitions by private equity firms appear to be picking up. What do you see as the principal reasons for the increase? What kind of special approaches are needed to complete some of these deals in areas like pricing, structuring, and which targets are available? Adams: A tremendous amount of money has been raised and is available to be invested. With the improvement in the financing markets in the last several months, particularly the high-yield market, and the perception that the economy is getting stronger, deals are getting done at a faster pace. People are deciding that now is a decent time to invest. Second, our perception has been that the deal flow has tended to come in waves over the last two years. You get a rush of deals over a one-to-two-month period and then things slow down again. It appears that immediately following Labor Day, activity has again dipped. In terms of special approaches, being creative about new sources of money and more institutional sources rather than traditional bank borrowing is advantageous. Also, we’re trying to bring together pieces that allow us to contribute something that not everybody can get their hands on. That gives us an edge in pulling a deal together. Szigethy: I think that a lot of good deals weren’t sold during the rough years – 2001 and 2002 – and that overhang is being brought to market in 2003 as owners have decided that it was a good time to think again about selling. The other reason that the market is picking up is that lenders are loosening a bit. Lending ratios, as a multiple of EBITDA, are reaching or exceeding four times and are probably up about one-half to three-quarters of a multiple from where they were 18 months ago. One approach that a lot of buyout firms have taken is simply to pay more. So prices are up. Our approach is what we have always been doing, which is to focus on very small deals, which are transactions in the $10 million to $100 million dollar range – with our specialty in the $25 million to $45 million dollar niche. A lot of mid-sized firms don’t go down to that category so prices are still reasonable at the lower end of the middle market. Gonyo: Joe and Bela are right about the tremendous amount of money to be put to work, so firms like us have to find a niche or an angle in the process to compete effectively as purchase prices are increasing again. Our strategy is to acquire a business in partnership with either a prospective CEO or one of our Executive Advisor Partners. That allows us to pursue underperforming situations or companies that may need help taking the business to the next level. The typical executive we would partner with previously would have run a billion-dollar sized entity within the same industry we’re pursuing and, hopefully, great industry knowledge and contacts. We mutually devise a value creation plan for the next five years with specific ideas of how to improve the business. As we’re often competing against five or six other parties when putting in our final bid, we must be selective in the transactions we will pursue. Max: I’m not sure I would agree with the assumption that the market has gotten more active recently. There’s certainly something to the fact that after the summer it has quieted down again, and it’s a lumpy market in that sense. From our perspective, we try to do a couple of things. Internally, we have an operating management group so that we can look at situations that may be outside of what other sponsors can do and bring something extra to the transaction. Our sense is that in this market the prices you’re going to pay are pretty full. You need to have a value-added perspective. Also, while we work on increasingly larger deals, we also remain very active in the smaller m&a market, especially in terms of corporate development for platform companies. That’s where we’ve created the most value for our deals. It has been very successful for us. Jennings: From my perspective the fog is clearing a little bit. We are no leading indicator. We focus on smaller, $5 million to $20 million dollar investments and we’re starting to feel like we have a little bit better foundation in terms of where things are going with the economy and some of the companies that we’re involved in, so we’re getting a bit more confidence on the deal side. Our angle is focused primarily on business services and information services. We have what I call a “horizontal approach” to technology. We invest in a lot of industries but generally behind a management team that is using technology in their business. That narrows the field a bit for us and helps us focus. One of the things that I tell the folks in our shop is that the world is too big and we need to work on making it a little smaller. With the Internet and all the information that is available, you could sit up all night reading about companies until it becomes hard to focus. That’s probably our biggest challenge. Rehnert: There has been a slight increase in the level of activity and I believe two things are driving that. One is that sellers’ expectations have begun to settle after a few years of a sustained economic downturn and malaise. At the same time, earnings are flattening out as opposed to going through the freefall that they went through the last couple of years. So there is a little bit more equilibrium, and that facilitates an environment where transactions can get done. M&A: What about the lending climate that generally has been described as softening? Is the credit flowing more freely? What have you experienced in multiples of EBIT? What are the signs that you see of a better lending climate? Max: You actually have to segment the market. If you’re looking at the market where we’re most active – $100 million or more in senior financing – it now has some efficiency and liquidity. If there is some confidence in the underwriting, the deal is going to get done. A lot of that has to do with the support in the high-yield market, which is an attractive market right now. Frankly, it’s driving some of the aggressive pricing for deals of that size and up. In the smaller end of the market it has gotten better but it’s still a club culture. You still need to go around to the five to 10 usual suspects and get them to sign up for the deal. There are not true underwritings going on in the sub-$100 million market at this point. Better than it was, but more different than the larger deals. Gonyo: In the sub-$100 million financing market, there is actually more new interest from providers in the market. After a contraction in 2001 and 2002, the number of financing providers has significantly bounced back. When GE acquired Heller Financial, several new groups spun off to do their own thing or go to other institutions where they beefed up their corporate finance and leveraged cash flow and lending practices. Existing lenders in this sub-$100 million market have also benefited from the increased liquidity in the market by making it easier to syndicate their loans. Max: Initially, there was contraction followed by the creation of some new lending groups. It took some time for these new players to get some traction and to start doing business. Today, there is an active market. That being said, if you can’t line up your own financing, if you can’t line up all the players necessary to “club” the deal, the deal doesn’t get done. It isn’t like it is in the larger deals where someone is putting out underwriting letters. Adams: Debt markets are much stronger than they were two years ago due to the arrival of new players. CapitalSource, which just went public, is a good example. There must be 10 business plans circulating from groups trying to do the same thing. The void in the higher-yielding middle tier has been filled very, very quickly. For larger deals, banks are competing against a revitalized high-yield market, almost a hot market. It’s a very different financing environment than even six months ago. Szigethy: Just to talk numbers for a second, at the peak of the market, in 1998 to 1999, total debt divided by EBITDA was probably around five times. At the bottom of the market it dipped to maybe 3 to 3.75 times. On a recent acquisition of a company called Nordco, a basic manufacturing company, we were able to get four times. And on a deal that’s in the pipeline now under letter of intent, we’re probably going to be getting about 4.25 times. So that’s total debt to EBITDA on deals in the $40 million to $60 million range. Rehnert: That’s very consistent with what we see. We have both a private equity fund and a mezzanine debt fund. With mezzanine debt, we have seen the debt coverage go to 4.2 times and in some deals people are trying to push it to 4.5 times. The pricing is getting tighter and that’s a sign that the market has come back to life. There are new players working in the mezzanine area but also in the bank area and the senior area. Players like Madison and RBC are still out there. There is a host of new players that five years ago were not backers but now are very active. It seems at the moment to be a very robust market. Max: But to give you a sense of contrast, we’re looking at a transaction with a purchase price of half a billion dollars, and we will probably get five times EBITDA in terms of leverage for that transaction. It gives you a sense of how active and strong the institutional market is. Jennings: It’s a classically cyclical business. When you look at CapSource, you see a real financial arbitrage. They are charging a very hefty rate in a low interest rate environment. The most telling signal I saw recently was a guy that I’ve known for about 15 years who used to run one of the major leveraged lending groups at a bank. He now has private equity firms trying to give him $300 million or $400 million to start up what is basically a knock-off of CapSource to deal in the sub-$100 million market. He saw an arbitrage possibility for the next three years that he thought would be a great money-making opportunity, but didn’t want to start a business that would go beyond that time frame because he thought the market would get overly competitive again. Based on this type of activity, it looks like debt will probably get easier to line up over the next year. M&A: There are a lot of potential deal drivers out there. Are there any in particular that whet your appetite for making deals, anything from one-off transactions to consolidation plays to buildups? Jennings: We like the information and business services space. We bought the disaster recovery business from GE. I think that what you’re seeing in that area is clearly a post-9/11 change in attitude, although it has been somewhat overshadowed by a tough environment. For instance, spending is being held back even though companies know that they want to upgrade their disaster recovery plans because it’s deferrable. Our business is growing very nicely and I think the next few years look good there. This year, we added to the security sector with a pre-employment screening company, which also is an element of the post-9/11 trend, and that business is incredibly strong. It’s up 50% a year for the last three years. It’s a great transaction-processing business model with recurring revenues and high margins. There is quite a bit of private equity activity in that area and we’re looking at a couple of other opportunities there. Adams: We have been spending most of our time in financial services and outsourcing. We like the area because there is still an ability to create businesses and to buy properties that are not auctionable – almost “build” versus “buy.” Max: We continue to be opportunistic. I would answer the question by noting that there are probably some things in the current market that we know we don’t want to do. That’s probably easier than to say we’ve found things we definitely want to do. We want to avoid cycles that seem to be near peak – like housing and auto OEM. Those are difficult industries to predict, to know where they are going and how to play in them. We have done lots of transactions in those areas in the past but we have pulled back a little bit today. Outsourcing has always been a popular area, and we’re looking at it, too. It plays so many different ways and is so broad that a lot of people are looking at the outsourcing concept and not bumping into each other. Szigethy: I would piggyback on that thought with another strong trend. Being generalists we often have invested in manufacturers. With China making more and more of what we all consume, that’s something that we have to pay a lot more attention to than we ever did before. Two of our colleagues are in China today and we had another partner go over there last month. We’re very concerned about the threat that it poses to the companies that we’re thinking about buying. And we’re working to make sure that the companies already in our portfolio are actively addressing this threat. M&A: Can you identify areas that seem to be ideal for private equity buyers but that strategic buyers are not particularly interested in? Do they offer the chance to avoid auctions? Max: It’s most applicable to those industries where there is just no liquidity from the strategic point of view. An area that’s starting to rebound is specialty chemicals. There is just very little activity coming from the strategic side. It’s starting to pick up again and properties are starting to come back into the market. That would be an example of an area that the private equity guys have found a window for themselves. Jennings: I just think there always are strategic buyers. But in a trend that continues from last year, there is a lot of distraction so we’re seeing less competition now. We’re also looking quite a bit at the education sector, where 98% of the business is non-profit, so your strategic buyers really aren’t strategic buyers. There are a few companies that have done really well. As an example, we’re about to buy a non-profit accredited university and convert it to for-profit. However, even with 98% of the sector run by non-profits, there are still some serious strategic buyers in the business. Max: Investment banks are basically not pitching strategic exits. Instead, they look at private equity values as being so robust that it serves as the baseline for the exits. Jennings: They are pitching the certainty of private equity. They can negotiate with a couple of partners around the table and they know that they’ve got the decisionmaker. These days you’re getting more and more uncertainty out of the corporate structure. We just sold one of our companies to a private equity buyer and certainty was part of our consideration. We had less certainty that the strategic buyers would be there at the end of the day. Gonyo: With the maturing and growth in the number of private equity firms, the resulting universe of portfolio companies has expanded dramatically. Most private equity firms typically plan to sell their holdings in five to seven years and, accordingly, there is less of a stigma to buying a private equity firm’s portfolio company. Also, if there were no strategic buyers to buy the business before, financial buyers may be the best sale alternative today as well. M&A: Club deals seem to be increasing and being used in more situations. What is your take on them? Rehnert: It seems like they are still primarily a phenomenon in the large-cap segment of the market. I haven’t seen much in the middle market. Adams: In a mid-market deal, occasionally you partner with someone because there is a particular fit or skill set you each bring. But it’s more difficult to manage a transaction with a partner, much less a club. In the largest auctions, there is an element of risk syndication. Also, you often start with 20 firms looking at a deal and then it separates out to two or three clubs. If the deal doesn’t work out then everyone takes comfort from knowing that other brand name firms made the same bet that they did. However, while the general partners are syndicating their financial risk, in some cases the LPs are concentrating theirs. Rehnert: My guess is that at some point the gatekeepers on the LP side are going to have to figure out how to stop bidding up their own deals, because that’s what is really happening. The other interesting part is the phenomenon in which the clubs are going after deals. The deal has been won and the number two and number three bidders sort of say they have already done the work, the price spread isn’t that great, and so we will step up for another $10 million. And they all come in. I think that’s a temporary phenomenon. People are going to start to figure out other ways to approach that. Some investment banks may want to participate in the clubbing and they are basically afraid that you’re going to take away the competitive nature of the process. M&A: Going-private deals are increasing mostly because of Sarbanes-Oxley compliance pressures. In the past, most of you had considered buying public companies too much of hassle. How do you feel about it now? Jennings: There has been opportunity in micro-caps, but they have really traded up. We have looked at a number of larger firms in the $100 million range, but the main problems are exactly what they have always been – fairness opinions and other issues around actually being able to get approval for a transaction like that. Many of these companies actually had a lot of cash, and that was a part of our evaluation, so there was an issue there. I still think that going-private deals are going to be happening increasingly going forward. I was recently on the phone with a CFO of a company that’s going to go public next year in one of the bigger offerings. He said his company basically had to spend $2.5 million to $3 million a year just to comply with Sarbanes-Oxley and that their D&O insurance was well over $1 million. It shocked me because that’s a huge change from even five years ago. They had to build those costs into their model to go public. This is an international company and they really needed a branding event. Unless they really need it strategically, a lot of folks really can’t afford that exit route. There are going to be companies that get ratcheted up to comply. I think these guys went a little beyond the normal call in their costs, but the level of paranoia of their directors was very high. Max: We’re seeing a lot more public-to-private deals and we’re more open to doing them. We have pursued a couple. With us, the problem isn’t so much the issue of fairness opinions and the like because we’re doing slightly larger deals, so some of those costs are a little easier to bear. I think the interesting thing in public-to-private deals is that the private market still provides the baseline valuation. There is no arbitrage value per se. We’re looking at deals that are trading below what the private market would value them at and by the time we buy them or someone else buys them, they are fully priced. Gonyo: They have worked for us. We have done three going-privates in the last three or four years, all as add-ons to existing portfolio companies. We own Bushnell, which makes binoculars, telescopes, range finders, and other sport optics. We acquired two orphan sunglass manufacturers, Bolle and Serengeti. None had any following from the public markets as they were below $100 million in revenue. As basically strategic acquirers, we were able to take out significant expenses and convince management that this was a good deal for the shareholders so that it was a win/win situation. Szigethy: I think it’s a very rich field and it will continue to be a good source of opportunity. We have been working on one for the past year. We think it’s a good place to do deals. Rehnert: The area seems as if it’s going to be more and more fertile. With the crackdown by Elliot Spitzer on the coverage by analysts and the division between analysts and investment banking, you’re going to find more and more orphaned companies that don’t have an analyst to cover them, and it isn’t worth bankers’ time to invest in researching them. I think that will lead to more companies trading at lower multiples over the next 12 to 24 months. M&A: Private equity firms have been faulted for not being more aggressive in approaching diversified companies and persuading them to sell non-core operations. What are you doing to try to pry loose some of these things that would be better owned by a private equity firm than by a diversified company? Szigethy: We are very proactive in deal sourcing. We have four people on staff to do it full-time. In addition, six months ago we retained an outside intermediary who works with us on smaller deals. His job is to go to the Fortune 500 and pry out orphaned divisions. So far he has dug up a lot of opportunities but we haven’t closed on one yet. His pitch is that it makes more sense to talk one on one with a potential buyer and do something quickly and quietly because the division is so small that it isn’t worth taking it to market and going through a nine-month auction process. Max: My guess is that it’s an active strategy for almost everyone in the market. It may be moving a bit slowly, but not because the big companies aren’t being called on. Either the sellers are not ready or price is an issue. A lot of them haven’t figured out what strategy they want to pursue and they are concerned about making the wrong move. Adams: I don’t think that the private equity firms could be any more aggressive than they are. It’s a bit of a mystery why more corporate divisions aren’t being sold because this is a great time to sell. I am positive that the bankers are making that pitch. A seller today feels compelled to conduct an auction because that’s what everybody says you have to do. So how do you sell a business that should not be auctioned? It takes experience and sophistication to do that. M&A: What is the climate as far as competition is concerned? How intense is bidding? Are you regularly competing against strategic buyers? Are you competing against other private equity firms? Rehnert: The kinds of things we buy typically are scary for most investors. There is usually less competition associated with those kinds of properties than with a high-quality company that’s run by a top-flight management team. We tend not to spend much time on those because we don’t think we have much on the private equity side to add value there. On the mezzanine side, actually, we focus exclusively on high-quality companies with good management teams that are backed by the best sponsors. Our private equity group isn’t competing with the clients of our mezzanine fund. We look at totally different things. What we see on the mezzanine side are intensely competitive auctions. Frequently, we will be backing a group and they will stretch very far and get outbid. But on the private equity side, we like to turn around complex things, and it seems like there are fewer players that want to dive in there. Szigethy: Our deal sourcing team went back and looked at the transactions during the past 12 months that we were interested in but lost out to another buyer. It turns out that 25% of the time a strategic buyer bought the business and about 50% of the time it was a financial buyer. I’m not sure how the rest were categorized. Max: I think there are really two kinds of auctions. There is the free-for-all that is just very, very tough to win. Then there is the kind where there is a less-formal process. In the latter case, there is a lot of discussion. You have a chance to spend time with management in a less-formal process. Although no one is designated the winner, you sort of know you are in the running when you invest the time, and you develop a much higher hit rate. We’ll participate in lots of auctions to see what’s going on in the marketplace, maybe even to catch a break. But it’s really a certain type of auction that’s most attractive and it tends to be a relatively narrow auction process. Jennings: A lot of it is a direct function of the size of the deal. Our investment size is small enough that when you go down to the $10 million and under EBITDA range of companies, you’re going to see a lot more opportunities to go in and negotiate something directly. We also try to look for situations where the management team has a good deal of power in terms of directing the sale. The smaller the company, the more power the management will have, and in a lot of cases, they are very valuable to that business. A $50 million EBITDA company is very attractive to a lot of folks, but you have a whole different dynamic going on in the sale process. Max: That’s certainly one side. The other is growth. We tend to stay away from high-top-line-growth businesses. We just can’t compete in those auctions. We would rather find a low-growth business. It narrows the field of who’s interested. Then, we try to bring some growth strategies to the business. When we’re right, it works very well. But it takes a lot of time. M&A: With the reduction in the dividend tax to 15%, some commentators have said it may be conducive for private equity firms to pay out dividends to investors rather than bet all returns on an exit. What is your view and are you developing any kind of technique or deal structure to take advantage of the reduced dividend rate? Adams: There certainly is no reason not to pay a dividend today. That explains high-yield dividend recaps as a popular way of obtaining liquidity. We expect that to continue. Jennings: In terms of building something significant, I just don’t believe that this tax structure is going to last forever. It’s nice for the moment, but I wouldn’t count on it five years from now. Max: It’s more of a window. Szigethy: At the end of the day we’re all judged on exits and cash on cash returns. So we’re trying to get the most cash from a full-blown exit. Gonyo: I don’t think the dividend rate change is going to cause a major shift in our behavior. Most of our investors, or limited partners, are not taxpaying entities so they don’t care how they get distributions as long as they get cash. Of course, there is a benefit to the GPs or individual investors in the fund. Finally, with financing liquidity opening up, banks are becoming more receptive to allowing dividends to be repaid to owners through a refinancing. M&A: There seems to be a lot of movement from traditional investment banks to boutiques and the private equity world. Why, in your opinion, is this happening? And more important, what does it do for your ability to do deals and get a better deal flow? Rehnert: It makes the market more efficient. The influx of talented people mixed in is happening faster, is more competitive. The speed and sophistication with which deals are put together today compared with 10, 15, or 20 years ago is astonishing. I have a friend who teaches a graduate course in private equity. Things that took years and years to develop and the ways of thinking about things now are being taught to students who come into the business hitting the ground running. It’s an intensely more competitive, sophisticated business and marketplace. The bad news for limited partners is that over time that drives out the excess returns. I think that’s going to mean that for the business as a whole, the returns will come down. But there will be more people in there if it’s a bigger, more established, more sophisticated asset class as a result. M&A: Does it allow you to do any deals that you might not have been able to do in the past or perhaps develop areas of specialization that were not possible before? Rehnert: As someone who got into the business when I was young, I look at the intelligence, the skill level, and the knowledge base that some of the young kids in their 20s have coming in and I’m astonished by what they can accomplish and just how good they are. There is absolutely no question that they help us to do things that I certainly couldn’t have done when I was their age and I still can’t do now. Szigethy: Why are they coming over? We work in a very interesting business. Also, the LBO business and the world of private equity is taking over a larger and larger percentage of GDP so we’re in a growth business. You put those two together and you attract talent. Gonyo: We also are attracting quality CEO talent as the private equity business is becoming more institutionalized. We’re able to recruit very high-quality CEOs that came from billion-dollar-plus sized companies. Ten years ago they wouldn’t have had any interest at all in running a middle-market business. Three to five years ago, we were competing with inflated stock options or dot-com get-rich-quick schemes. Today, they see owning a meaningful stake in an LBO as a viable roadmap to create personal wealth for themselves. M&A: Once somebody makes that crossover, to the operations side or the deal side, don’t they seem to stick with you folks? Max: The junior people basically need to put their time in with the firm in order to build up an equity position and gain that opportunity. Once they’ve made the decision that private equity is their career, it would be an unusual thing for them to get out. My sense is that once you pull yourself out of corporate management and become a partner with private equity, it’s hard to go back. I think that the companies that are looking for managers have a hard time understanding someone who spent the last three to five years in private equity, even if he or she ran something. I think that the style and the independence that someone develops working with private equity are hard to give up. Rehnert: I think there are some junior people who decide that the pace and the intensity of private equity is just more than what they really want from a lifestyle perspective. Private equity is a demanding business. To do it well at the highest level is a 24/7/365 business – not that you have to be in the office constantly but you have to be available and willing to jump on a plane on short notice. You are in the deals business and so you have to react to the timing of the deals. You have emergencies at portfolio companies and you have to jump on those. Some people just say that on a personal basis, it’s more intensity than they necessarily want. So we have actually seen some people opt for a little less grueling pace. Max: We have very few hires in our firm and the only hires we do have are people who have done their two years in an investment bank. We bring them in for a couple of years and then we figure out what happens from there. So they have already done the investment banking. Actually, the issue is one of getting them to shift from an agency point of view to a principal point of view. That’s a tough one. That’s actually where we run into problems – where people just don’t get that you have to think of it as your money and how to invest it wisely. Rehnert: We hire both former investment bankers and former consultants – about half and half. Both are service providers. But both face different nuances in making a shift from being an agent to a principal. Roundtable Participants Joseph Adams Partner Brera Capital Partners Jeffrey Gonyo Managing Director Wind Point Partners Mark Jennings Managing Partner Generation Partners Adam Max Senior Principal The Jordan Co. Geoffrey Rehnert Co-CEO The Audax Group Bela Szigethy Managing General Partner The Riverside Co. Copyright 2003 Thomson Media Inc. All Rights Reserved. http://www.thomsonmedia.com http://www.majournal.com