Last July a large Midwest-based investor started working on the acquisition of a major manufacturing business--a transaction worth several hundred million dollars--and everything looked good. Banks preliminarily offered to provide senior debt equal to about five times the target company's free cash flow. During the next 60 days, however, credit markets tightened. Despite the target company's continued strong performance, available debt financing dropped to three times free cash flow. Nevertheless, the seller wouldn't hear of a significant price reduction, and the transaction fell apart.
It wasn't the only one. The media were filled with other examples of cratered deals--including the aborted buyout of Johns Mansville Corp. We lawyers specializing in private equity nervously watched other deals evaporate. Cumulative numbers hint at the behind-the-scenes frustration: Early estimates indicate deal activity for the year 2000 may have declined by as much as one third from 1999 levels--with much of the slowdown coming in the second half of the year.
If your company is looking to sell corporate properties during the next year, it might be well advised to wait out the troubled debt financing markets. The patient seller who keeps track of these markets through knowledgeable bankers, investment bankers, and other advisers will be able to, when credit eases, demand a higher price.
But if your company is looking to buy corporate properties, it should follow the lead being set now by private equity experts: Look for undervalued small to mid-cap public companies, asset sales by troubled companies, and auctions of under-performing properties.
While bank funds have been drying up, private equity firms have just gone through the best fund-raising years in the history of the industry. Many are sitting on an unprecedented amount of equity capital and wondering where to invest it. The best answer, they're finding, is to scoop up "orphaned" public companies as well as troubled enterprises, both public and private.
The slowdown was tough for buyout investors because senior lenders, concerned about soft corporate earnings and fearing a continuing economic slowdown, reduced loan amounts to leveraged acquisitions by 30-50 percent during a three-month period. The even more skittish subordinated debt market was nearly shut down completely. And as key intermediaries left their jobs at Donaldson, Lufkin & Jenrette, Inc., and other leading subordinated debt providers, it became clear that this source of capital wasn't returning any time soon.
Sellers were unaware of these conditions--or unwilling to acknowledge them. They kept looking at the values established for comparable properties in recent deals, and expecting high prices for their properties. No matter how much in-house counsel tried to advise company owners that the money was just not available, their bosses stuck to the reasoning that short-term financing difficulties did not reduce the intrinsic values of their businesses, so why should the price tags on their companies get slashed?
In the past, when there have been similar significant gaps between sellers' and buyers' expectations, deal activity has remained slow until a measure of equilibrium has returned to the marketplace. For example, in the late 1980s and early 1990s as lenders were suffering through the worst of the U.S. banking crisis and the junk bond market was collapsing, acquisition transaction volume declined precipitously. Then it was many months before the price expectations of sellers came down and the debt markets recovered sufficiently to return acquisition transaction volume to previous levels.
While the relative unavailability of debt financing caused some headaches, today's private equity investors are somewhat optimistic. During a record-breaking 1998 and a healthy 1999, buyout funds are estimated to have raised in excess of $90 billion--up dramatically from an estimated total of $60 billion for the prior two-year period. Largely on the strength of a small number of megafunds, fund-raising continued at a similarly robust pace in early 2000 before fading in the last half of the year.
To put all that money to work, some private equity firms first may look to increase the amount of equity capital that they pump into each transaction. This would continue a trend toward larger equity commitments that began several years ago. Primarily at the request of lenders, equity investors have steadily increased the percentage of equity in acquisition capital structures from 10 percent or less to 25-35 percent. Going forward, we may well see leveraged acquisitions routinely done with 50 percent equity.
A much more dramatic development would be for some private equity firms to go the next step and provide all or a portion of the required debt financing, thus doing an end-run around the tight credit market. In the right circumstances this strategy could pay off. You'll see more of this, but it could get really dangerous and ugly very quickly. We have all seen bridge loans turn into diving boards so investors are likely to look for more creative ways to deploy their funds.
Already a number have shown increased interest in acquiring undervalued, small to midsize public companies. As evidenced by the 39 percent drop in the Nasdaq Composite Index during 2000, many of these small to midsize public companies have fallen out of favor with investors. Private equity firms are finding that the cash flow multiples to be paid for these orphaned public companies are lower than those in the private market. During the time it takes for private seller expectations to moderate, this public market price advantage is likely to continue. As a result, many private equity firms and their lawyers may increasingly focus on going-private transactions.
During the last several months, our private equity clients have been involved in a growing number of proposed and completed going-private transactions. Ongoing interest in public companies indicates that there will be more of these deals on the horizon.
While searching for orphaned public companies, buyers of all stripes may also think about scooping up troubled businesses. We private equity counselors have seen a substantial increase in interest in under-performing companies that investors believe can be rehabilitated for substantial gain. This is a high risk/high reward strategy, but could represent an opportunity for placement of large sums of equity capital.
Partnering with quality management who can turn around troubled situations will be of increased importance in these deals. Expect the bidding to be furious for managers experienced in rescuing troubled companies.
Likewise, insolvency lawyers will probably be in great demand as law firms rapidly build their insolvency staffs in anticipation of the coming tidal wave of restructurings and restructuring-related acquisition activity.
What does all this mean for the lawyers and other advisors who spend their time buying and selling companies?
More than any year in recent memory, 2001 will be one in which careful observation of, and prompt reaction to, changes in the financing marketplace will be essential to making sound strategic decisions. To the knowledgeable and nimble will go the spoils.
Kevin Evanich is a partner in Kirkland & Ellis' Chicago office.
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This article is reprinted with permission from the March 2001 edition of Corporate Counsel. Ac 2001 NLP IP Company.