From my prior post, we know that the transaction environment in the middle market is poor at best, but more likely toxic, much like the balance sheets of the banks that are constraining it.  I harbor no illusions that the financial bailout program controversially voted into law will lead to expedient removal of the most substantial roadblocks and return us to leverage buyout nirvana.  No, ae are in for chilly times.  The question is how long will the ice age last, and what will it look like?  I offer some thoughts/predictions here on debt availability, LBO transaction volume and valuation trends.

Thawing of the Polar Ice Cap

If a return of cost effective money is the rate limiting factor to a more robust transaction environment, it should be the place we start in our effort to identify potential signs of a turnaround.   There is both good news and bad news here.  The bad news is there will be no easy defrosting.  The reality is that cash flow lending is well down the debt hierarchy and we need to melt everything in front of that first.  That starts with the multi-trillion dollar commercial paper market.  It will simply take time for the heat to reach the more subordinated product suite, despite the fact that the mezzanine market is already smoldering.

Additionally, while the bailout might bolster the balance sheets of a broad swath of lenders, the ripple effect of a deep economic contraction is going to lead to a number of them going out of business (many of them due to their exposure to Fannie Mae and Freddie Mac stock).  A contraction of capital availability and the sources to provide it, is going to cause those with fresh capital to lend to be inundated with deal flow.  I’ve heard from a number of mezzanine funds that they are receiving inquires at unprecedented volumes.  If someone can provide senior capital then I would expect they would be drinking from the firehouse as well.

The good news is that pockets of debt capital do in fact exist outside of asset based loans and mezzanine. debt  Recaps such as the Furminator and Charlesbanks buyout of Tecomet, are proof positive that deals can get done if the capital structure is right and the prospects for the business are sufficient to support the underwriting risk.  Sure fees and costs associate with such deals have increased and will remain high for the short term, the well will not go dry.  That said, don’t look for the polar ice cap to thaw until unemployment peaks and the signs of recovery are readily evident.  Look for signs of life in 2Q2009.  Albeit maybe small signs.

Bridge To Nowhere?

The most famous bridge of this campaign season, the proposed bridge to Gravina Island,  has been used as a symbol for forward leverage buyout activity — non-existent.  Given the lack of debt availability who could blame some from drawing this conclusion.   Long short, I’m not buying it.  At least not totally.  I don’t expect numbers to be strong mind you, but there will be deals that will get done, especially at the lower end of the market.  There are enough of the following combination’s, that will keep wheels from grinding to a halt (or the well going dry) assuming business performance continues to the positive side, and in certain verticals it will:

> Solid local company + Regional private equity fund + Regional lender

> Solid local company + National private equity fund + Lender who is also a limited partner

> Solid small company + All equity sponsor (I’ve found more than a handful of these in existence)

> LBO firms who will take the re-levering risk

> Debt availability through asset based facilities and mezzanine lenders

Further, there are some really smart folks working in mega-fund land.  I suspect they will find ways to self fund, either directly or through a keiretsu, if the contraction is prolonged.  These are not patient fellows, based on my historical experience.  That said, the institutional loan backlog, which was $50 billion in September, will not clear anytime soon.  Further, we need banks to work through their self confidence issues, and start lending to one another.  It will also take time for government provided liquidity to work its way through the system.  Lastly, seller valuation expectations will also have to re-set.  This leads me to conclude that we will be barren for the next 3 months, but the wheels will get churning again soon thereafter.  In the meantime there will be a trickle large enough to sustain the system.

Not Exactly Bargain Basement

The remaining large inhibitor is the reconciliation of valuation between buyers and sellers.  At the highest level, limited partners are going to cut allocations to private equity funds if they feel the potential rates of return are falling relative to their risk profile.  As such, funds will not cede ground to sellers, but rather try and enforce lower valuations upon entry.  If you are a business that does not need to sell, you are likely going to take a wait and see approach.

The again, maybe you won’t.  Why would that be?  First, you are concerned about the change in capital gains treatment that the election might bring about and since your cost basis is so low, this may overwhelm your concern about hitting a high water mark on valuation.  Second, you might be willing to underwrite part of the transaction using seller subordinated financing, and in doing so still hit a reasonable number against a backdrop of uncertainty.  Third, you are facing an expiration of your debt agreement, whose renewal is no  longer a forgone conclusion.  If you wait until you are up against a cash wall, your valuation will decline precipitously, so it might be better to sell from a position of equilibrium, as opposed to one of weakness.  Fourth, you can recapture value lost today through an earnout structure into the future.  Assuming you are willing to wait and take the risk, this appears a viable alternative.  Finally, you just are not ready to cowboy up and ride your pony for another five years, when the next cycle may be upon us.

While the above may not be compelling to the broadest swath of potential sellers, a subset of those issues resonate with nearly everyone I have encountered recently.  While purchase price multiples will likely remain, on average 2.5x – 3.0x below their peak of 9.3x in 2007, mechanisms for bridging valuation will be found.

Against a back drop that seems to get more cloudy every day, I offer you a ray of hope, maybe a fleeting one. Tomorrow begins the new dawn, hopefully.