John W Kaufmann and Matthew Hamm
Kirkpatrick & Lockhart Preston Gates Ellis LLP
Private equity firms, having experienced a record-breaking first half of 2007, were among the first to feel the effects last summer when the credit markets came to a standstill.
Because of the unavailability of credit, some private equity deals were re-negotiated at lower prices. The Carlyle Group's purchase of Home Depot's supply arm, for instance, was negotiated down from an agreed US$10.3 billion to US$8.5 billion. Other buyouts were postponed due to the credit squeeze, and some were cancelled outright. In October, private equity firm Cerberus Capital Management withdrew its US$6.1 billion takeover offer for Affiliated Computer Services, citing poor debt market conditions. Cerberus was not alone in this. By November 2007, 76 deals worth US$202.3 billion were abandoned, a substantial increase over the 55 unsuccessful bids worth US$98.9 billion during the same period in 20061.
Private equity firms are sellers too, and many have found it increasingly difficult to arrange timely exits from investments. Potential buyers are unable to obtain necessary leverage, and even partial liquidity by means of dividend recapitalisations is more difficult as portfolio companies are unable to complete refinancings of their debt.
So far the turmoil in the credit markets has primarily affected the larger funds attempting the largest of deals. Middle market funds pursuing companies at the lower end of the buyout spectrum have been able to continue with fewer difficulties than the more leverage-dependant mega-funds. Middle market deals structured with non-syndicated senior debt, traditional mezzanine debt and private equity so far are weathering the credit drought.
But the credit market crisis may only be the jumping off point for much darker economic times ahead. Many economists believe the economy is already in recession, pointing to rising jobless rates, dramatic declines in hours worked, and a year-over-year increase in the level of unemployment. Even private equity funds focusing on middle market deals will struggle in a recessionary economy, as portfolio companies experience plummeting returns and have trouble servicing their indebtedness. Adjustments to a slowdown in the economy may be different for the mega-funds and the more flexible middle market players, but the entire private equity community will have to keep up with changes in the financial markets and business activity generally. Corporate buyers competing with private equity buyers and companies that are potential buyout candidates also will need to react to the challenges and opportunities that this economy will provide, and to the changing environment for private equity.
Tougher Due Diligence
Private equity buyers will be more conservative with their pricing and ever more attentive to the value of their targets. Increased due diligence will be essential in this process. Extended examinations of the assets and operations of a target will allow a buyer to evaluate carefully the returns the buyer can expect from an investment and determine appropriate pricing. More focused and intensive due diligence examinations will prevent buyers from overpaying and from acquiring a target that may be distress-prone in a recessionary economy.
As a result, there are likely to be slowdowns in the private equity deal process. The breakneck pace of deals in 2006 and the first half of 2007 will give way to a much more deliberate pace.
As fewer deals get done, sellers will have more difficulty attracting qualified buyers. Sellers can take steps to enhance their appeal. One method is to conduct due diligence on one's own company before a transaction process begins. Modifying contracts and leases affected by changes of control, addressing issues of management retention, cleaning up financial statements, and settling litigation matters can place a company in a better position for sale. Without preliminary due diligence and remedial action, a seller may present an incomplete picture to buyers or leave a potential buyer with sticky issues that it must face before or after a deal closing. This can depress the value of the business, causing potential buyers to lose interest, or provide a buyer with ways to re-negotiate or even back out of a deal. In a tough market, a motivated seller cannot afford to lose out on a deal because of poor advanced planning.
Sticking with What You Know
A slower economy and shallow credit markets will also encourage private equity to focus on increasing the value of existing portfolio companies. Improving operations and making other value-enhancing changes will increase returns when the private equity fund later decides to sell a portfolio company or to exit through an IPO.
Funds can also increase value by arranging "add-on" acquisitions that complement existing portfolio companies, permitting them to grow in size, strength and profitability before sale or exit. Add-on acquisitions capitalise on a fund's existing knowledge and experience in a business or industry, and therefore involve less risk in a chancy economy than the acquisition of a completely new business. Also, add-on acquisitions may provide an increased likelihood of investing without overpaying. Because a desirable add-on acquisition usually is a company with very specific characteristics that will provide a strategic fit with an already-existing portfolio company, there is often less competition for these kinds of targets, and less competition generally means fewer bidders and a lower price.
Aiming for Different Targets
During a recession, target companies in non-cyclical industries that tend to have strong cash flows in any type of economy will be most attractive. Private equity funds will focus more on investments in the healthcare and telecommunications industries, utilities and companies that provide basic consumer necessities, and move away from investments in consumer discretionary products and financial industries.
Companies in distress or in bankruptcy will also be attractive to private equity groups experienced with turnarounds and looking to make low-priced acquisitions. Acquisitions made out of bankruptcy proceedings have specific benefits to purchasers, who can pick and choose the best assets, leases, and contracts of the target; restructure employee relationships despite collective bargaining agreements; receive assets "free and clear" of liens and encumbrances; and avoid transfer taxes in certain circumstances.
Smaller Investments in Smaller Targets
With the credit markets in their current condition, private equity will be forced to reduce its reliance on leverage as much as possible. One strategy is to move away from control buyouts which require large debt financings, and to focus on putting capital into minority, growth equity or debt investments. This may not work for certain funds, which under their limited partnership agreements are not allowed to make non-control investments.
Another strategy adaptation would be to do smaller deals with smaller targets. Again, this will be easier for middle market funds. For a larger fund, making small investments would mean that the number of companies in its portfolio could quickly increase beyond the ability of the fund to manage its investments in those companies. Smaller funds' ability to work with smaller targets will continue to provide them an advantage through an economic downturn, and help them to weather the turmoil in the credit markets.
Middle market funds will continue to find it easier than mega-funds to obtain debt financing. Private equity's traditional sources of debt such as the high-yield bond market and syndicated bank financing may remain unavailable, but the middle market typically does not rely on these debt sources. Single banks can provide the debt for many lower-middle market deals. Middle market funds willing to scramble a little can also assemble homemade syndicates of a few or even several banks to cover their larger deals.
Having sellers participate more in the financing of deals is another way private equity will adapt to the credit markets or a recession. Sellers will be asked to take back promissory notes in the sales of their businesses, thereby requiring buyers to raise less debt and equity financing. In return, the seller may receive a more favourable price – or get a deal done that couldn't be done otherwise. Taking back a note also allows a seller to spread out part of his taxable gain from the sale over a period of time.
Sellers may also be asked to participate in acquisition financing by "rolling over" part of their equity in the target company into an investment in the buyer, as a part of the purchase transaction. For the seller, continued ownership means continued risk but also continued participation in the upside of the business.
Earn-Outs - Bridging the Price Gap
Sellers can increase the likelihood of closing a deal with a risk-averse buyer by taking on some of the future business risk. Agreeing with a buyer to accept an earn-out component to the purchase price will allow the seller to bridge a difference in views between buyer and seller on the value of the business. With an earn-out, the initial purchase price is reduced, and post-closing payments are made to the seller contingent upon future sales, earnings or other performance of the business. Sellers with faith in the strength of their businesses can entice buyers with a lower up-front price and, therefore, lower financing requirements.
Earn-outs can be very tricky to negotiate and document, and require the assistance of experienced counsel. A properly documented earn-out provision will provide for a variety of contingencies such as future acquisitions, changes in accounting practices, allocations of overheads among affiliated corporate groups, sale of the business during the earn-out period and management changes.
Expect Some Changes, and More of the Same
Private equity transactions though slower in pace and reduced in numbers, will continue on through rocky credit markets and an uncertain economy. Buyers and sellers may not be able to operate in entirely the same ways as during the buyout boom of the last two years, but only relatively modest changes in strategy, structures and process are likely to be necessary.
Investors continue to have faith in private equity despite the credit markets and the economy. Fund raising continues to grow even as the numbers of closed deals fall. Institutional limited partners that regularly invest in private equity funds show no signs of moving away from private equity – some bigger players such as the Arkansas Teacher Retirement System and the Washington State Investment Board have even increased their private equity allocations.
The huge quantities of capital being raised by private equity funds without letup will have to be deployed somehow. Although changed financial markets and an uncertain economy may lie ahead, private equity will weather rainy days by doing what it has always done well – adapting, and finding new ways to get deals done.
John W Kaufmann is a Partner with Kirkpatrick & Lockhart Preston Gates Ellis LLP whose practice includes private equity, mezzanine and venture capital financings and mergers and acquisitions. Matthew Hamm is an Associate working in private equity. Both attorneys are located in the New York City office.
This article first appeared in the February issue of The Metropolitan Corporate Counsel.
1 Martin Arnold and James Politi citing Dealogic (6 Nov 2007). Failed Buy-outs Double to Exceed $200bn. The Financial Times. Retrieved 17 January 2008 from http://www.ft.com/cms/s/0/f4357294-8c96-11dcb887-0000779fd2ac.html