A 2008 Buyout Primer
With Several Dealmakers from KeyBanc, FOCUS, RSM McGladrey, and Strength Capital Speaking Their Minds
First, the Bad News
Emergency rate cuts from the Federal Reserve that reek of panic.
Political uncertainty with anti-business candidates in the lead.
An economic slowdown as a best case scenario in the face of a probable recession.
Huge buyout deals melting down.
A credit crisis hanging around like an unwanted holiday guest.
Certain industries in and around the housing sector are imploding.
Other industries are slowing down.
And after the first two months of 2008, the overall financial outlook isn’t any cheerier.
Now, the Good News - in One Important Sentence
The middle market looks fairly healthy and the place to be in 2008.
2008 Outlook from Several Investment Bankers
The first half of 2007 saw incredible deal numbers, driven mainly by the huge LBO transactions. As the subprime mess and its effects on the rest of the economy started to become apparent, deal volume slowed, and then came to a screeching halt for above the fold deals.
Even though the middle market did slow down, we didn’t see the same crash that the large LBO deals did. What does that mean for 2008?
M&A Chicago asked Fred Floberg, a regional managing director at middle-market investment banking firm FOCUS for his thoughts. “I think you’re going to continue to see flats or declining levels. The middle market doesn’t have the volatility of the larger markets. We have lower highs and higher lows. Remember, we’re working from very high levels,” Floberg said.
Kip Clarke from KeyBanc Capital Markets largely concurs with that opinion, predicting that, “Volumes overall in the middle market will only be 5-10% off of last year.”
There is some hope that the rate cuts at the end of January from the Federal Reserve should eventually prove helpful to the financing markets. FOCUS’s Floberg says, “I think it’s too early to tell how quickly they are going to take effect. I think there are still a lot of people out there that are worried about some of the other fundamentals, in particular the economic outlook in general.”
Mark McCammon, managing partner at Strength Capital Partners concurs, saying, “It’s too early to tell if the rate cut will help with liquidity.”
Plentiful Cash, Foreign Buyers, Hungry Strategics, Realistic Multiples
The positive factors driving middlemarket deal activity are many.
KeyBanc’s Clarke says, “Our outlook is still optimistic this year in the middle market because you still have reasonable equity values, you have lots of corporate cash, you have strategics coming on strong, and you have foreign strategics.”
There is still a tremendous amount of capital that private equity needs to put to work. Strength’s McCammon says, “We believe it is easier to get a transaction done now than it was in the fourth quarter of 2007.”
Michael Grossman, a director with the National Transaction Support Services practice from RSM McGladrey also notes that it is likely that some of the larger private equity groups will increase their presence in the middle market. “I think everybody is going to come down market. We’re still seeing an active middle market”
The possibility of strategic buyers coming to the fore is also a popular theme. After spending the last couple of years frustrated due to financial buyers coming in and bidding up deals to multiples that the strategics were unwilling to pay, there is a sense that strategic buyers may play a much bigger role in 2008.
FOCUS’s Floberg notes that this can only have a beneficial effect on the middle market, due to the fact that strategic buyers will be more competitive with the financial buyers on price and terms.
Foreign strategic buyers also have an advantage due to the currency situation they currently find themselves in. Up to this point though, Strength’s McCammon says that as far as pressure from strategic buyers, “We have not really felt that, not anymore than it has been.”
The New Due Diligence: More, Better, and Third Party
This is not to say that the middle market landscape is going to be the same as it was in early 2007. Pricing on buyout loans is higher, and leverage has declined.
Along with that, FOCUS’s Floberg observes, “Loan quality is now paramount.” The lenders are also negotiating terms from a much stronger position than they were in a year ago. Strength’s McCammon notes, “The PEGs and other companies using acquisition financing in the past few years have really used all the liquidity out there to negotiate terms that were very favorable for the borrower, the banks and other lenders are using the credit crisis to pull things back in.”
Due diligence is another factor that has changed over the period of a year. KeyBanc’s Kip Clarke notes that “There has been over the last couple of years a much greater diligence on accounting issues.” Lenders seem to be getting even more aggressive on the topic.
RSM McGladrey’s Grossman concurs, “We’re seeing a lot more lenders hiring third party due diligence providers instead of relying on the sponsors to hire third party due diligence providers. Legal due diligence has always been there, but we’re seeing a push from the lenders to get us in the door before they actually agree to lend money.”
FOCUS’s Floberg says, “Quick due diligence is a thing of the past. No banker wants to get surprised after he makes the loan.”
Difficult Sectors - and a Really Ugly Sector for 2008
Not every middle market sector shares the above optimism.
An economic slowdown caused by soft consumer spending will probably have a detrimental effect on retail sectors and their suppliers. January retail sales numbers were weak, and layoffs and store closures are already starting.
Mark McCammon from Strength Capital Partners says that, “One thing we’re going to do is spend a little more time examining how a company might have done in late 2001 and 2002, because that will give you a point of view of how a company did in a down time.”
Another sector that likely won’t recover in 2008 is residential construction, with housing starts at their lowest numbers in more than a decade and borrowers unable to tap into the cheap mortgage credit that has been accessible for the past seven or eight years.
Key Banc’s Clarke bluntly stated, “Homebuilding is brutal right now.”
