It should come as no surprise to many that the debt capital markets are in disarray. I hesitate to use the common phrase “crisis” because deals are still getting done, which means there is capital available for quality deals with appropriate levels of leverage. What is clear is that the leveraged transaction markets peaked in May 2007, when it was announced that CDW would be taken private by Madison Dearborn Partners, LLC for approximately $7.3 billion utilizing 8.5x leverage. In the ensuing struggle to place the CDW debt, the market made some realizations — this was not good business, the risk reward profile was no longer aligned. In the months that followed, the perceived risk of a slowing within the U.S. economy, and therefore a potential rise in the associated default rates for highly levered deals, many with light covenant packages, became so fever pitched that the debt markets all but locked up. Banks took to lending only into their best existing credits, if at all, and, if so, on very cautious terms.

Debt is very important to the private equity buyout landscape, as purchase price multiples and leverage are highly correlated, as buyout firms seek to invest as little equity as possible in levered transactions. As the chart below illustrates, deal leverage and, as such, transaction multiples peaked in 2007. As the second chart illustates, the impact of this compression has been material in deals sizes sub-$100 million.

In my recent conversations with a handful of PE firms, I am hearing an increasing willingness to over capitalize companies on the equity side (50/50% debt to equity vs. 60%/40% or 70%/30%), with the assumption that they will lever and dividend out excess capital to investors at a later date, when appropriate. This assumption shows a belief, maybe lacking current foundation, that a thawing will occur. The new found predilection for over equitizing doesn’t seem to be moving the needle however, as buyouts are down this year, with $26 billion of domestic deals announced in 2Q08, down 93% from the same period in 2007 (Thomson Reuters). Further, the credit quality of LBOs has also declined, with 93% of 2008’s first quarter deals rated in the ‘B’ category, well below investment grade, up from 78% last year (Standard & Poors). While the bond markets are effectively closed to new LBOs, banks have still provided financing, says S&P, with “ample liquidity available from local lenders to fund private-equity transactions.” I’m not sure I would go that far out on a limb.

This leads me to the crux of this post, how are deals getting down in light of the fact that seller expectations have not fallen at the pace they have been undermined by available credit? The answer is buyers and sellers are bridging the gap with mezzanine debt or seller subordinated financing where mezzanine is not available. Seller subordinated financing is essentially deeply subordinated debt or preferred equity wherin the seller is the underwriter or part, or potentially all of the transaction. Popular back in the roll-up days of the go-go 90s, seller debt vanished from the scene due to a glut of available debt capital from third parties at attractive prices and structures. However, as lenders have retrenched, the idea has re-emerged. Take for example, the sale of Unilever’s North American laundry detergent business to Vestar Capital Partners for $1.08 billion. As part of the deal, Unilever will retain “preferred shares in The Sun Products Corp. [the NewCo formed when Vestar Capital Partners merged its business entity, Huish Detergents, with the newly acquired brands] with a face value of $375 million” per the company’s press release. If it wasn’t already clear, this was not a roll-up but a deal between a global enterprise and a firm with a $3.7 billion private equity fund.

While there is substantial mezzanine debt locked up in institutional funds, they remain frugal investors and focus on companies that have established and sustainable profits. A large portion of the lower end of the middle market is not an attractive mezzanine candidate, due to size and profit history, and service firms tend to get the cold shoulder relative to product firms from these sources. The benefits of seller subordinate financing are the note can be simplistic, flexible and easy to implement. The pitfalls are many however, namely that the seller is generally showing weakness if they express a willingness to be a financier of last resort.

Seller financing can be a useful tool, sometimes the difference between a deal that gets done and one that meets its demise. With any type of debt financing, the use of seller paper has long term implications, which can impose burdens on the issuer and the company. At the outset of engaging in a private equity backed transaction search, a discussion as to whether this form of financing is a realistic alternative and the structure that would minimize the associate risk should be undertaken. However, the more substantive reality is that sellers will need to come to grips with the fact that valuations have in fact contracted. Their choices are to consider lower prices, more structured deals, including earnouts or seller financing, or wait around for another cycle. This isn’t a lesson I enjoy teaching but it is a fact based reality.

Let’s just hope death spiral preferreds are not the next to make a comeback.

/bryan

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