On behalf of my firm (Cascadia Capital, LLC), I am authoring a four part series on the changing landscape for transactions in the middle market.  The first piece (below) is about the current environment.  Some of the material below you will recognize from earlier posts, however I wanted to begin in the beginning, because after all context is important.

The second piece, which I hope to publish in late November, will be a gallery of insights from my conversations with the private equity community.  I’ve posed three questions to a group of 15 private equity practitioners from across the country — a) How will private equity cope with a lack of cost effective debt capital to underwrite transactions over the next 12 months?; b) What will the private equity business look like in 2 years? In 5 years?; and c)  What will private equity’s legacy be after all the financial dust clears?.  This should produce great timely market insight.

The third piece will be on the viable alternatives we are seeing in light of the implementation of various government programs to stimulate the economy and lending environment.   Finally, we will do an update on market conditions during 1Q09.

For compliance purposes, I am posting all communications in the same form as they are released by Cascadia, including the company commercials.   Hopefully you will not find that too intrusive.


Redefining the Transaction Landscape in the Middle Market

Part 1 – A Broad and Chilling Effect

Bryan Jaffe, Senior Vice President, Cascadia Capital

Market Overview

The recent weeks and months have seen unprecedented change in the global financial system.  Not only have we witnessed record volatility and steep declines in market indices worldwide, but also government intervention at levels not previously contemplated.  A historic de-levering and re-levering of the U.S. and European banking systems is ongoing. In short, the pipes of the world’s financial infrastructure have become clogged. If businesses cannot gain access to cost-effective capital to fund their growth, our economy will contract sharply. And a depression – defined as three consecutive quarters of economic contraction as measured by GDP growth – seems possible, if not probable.  The markets are reacting negatively to these prospects.

While our first concern is with the national and regional economy, and the health and wellness of our local businesses, we believe that the current lack of debt capital will have a broad and chilling effect on the middle-market-private-equity-backed transaction environment.

In this multi-part communication series, “Redefining the Transaction Landscape in the Middle Market,” we will assess current market conditions, offer views from investment professionals on how the industry will adapt, and provide our advice and counsel as to how business owners might navigate the changing terrain.

Against this backdrop, there has been a precipitous decline in the amount of lending activity, which has negatively impacted deal valuations and volume. A contraction of both capital sources and products has hung deals and left businesses hamstrung.

Loan volume in the middle market was $4.6 billion in the first half of 2008.  At this pace, we will likely not crest the levels seen in 2001 ($11.9 billion), the previous low of the last 10 years.

In light of declining credit quality, loan volume has dried up within certain products. While loan default rates thus far pale in comparison to 2001, they have spiked off the lows seen in January 2008.

The percentage of leveraged loans in payment default or bankruptcy currently stands at 2.0%, far below the 10.0% peak levels of 2002.  However, a tidal wave of defaults, workouts and bankruptcies is sure to follow any significant economic contraction.

Sources of capital have also declined and, as a result, cost of debt capital has increased – in part due to less competition. Notably, the senior debt market has changed dramatically. Cash-flow loans for sub-$10 million EBITDA companies are gone. Syndicating loans has become increasingly difficult and deals include market flex language, which means that terms and conditions are not set until the deal is fully clubbed. Amortization schedules have accelerated with increasingly tight covenant packages. And leverage multiples have naturally declined.

Asset based and mezzanine financing have become critical tools in the leveraged buyout capital structure as equity as a percentage of total capitalization has reached an all-time high.

Debt multiples in leveraged buyouts have fallen to 4.9x, down from a peak of 6.6x in 2007.  As a result, average purchase price multiples for sub-$50 million EBITDA companies have fallen a full two turns to 6.4x from 1Q ‘08 and almost three turns from the peak in 2007.

The Impact

A lack of debt capital will fundamentally alter the middle market transaction landscape in the near term.  Leveraged buyouts at high water marks in terms of price and leverage are in the rear-view mirror.  Volume has come to a standstill and won’t pick up through year-end.

Private equity funds will rely on asset based, mezzanine and sell senior and subordinated financing to underwrite transactions. However, valuations must be reconciled for majority deal volume to pick up.

Parties who have no immediate need to engage in a transaction are likely to stand on the sidelines for the next two quarters, if not longer. But we caution companies to be proactive with respect to understanding the health of their lenders; this is important so companies aren’t thrust into situations where capital is required with limited time to plan or react.

That said, there remains significant capital accumulated in the hands of private investors. And while majority recapitalizations are under duress as a product, appetite for minority growth equity and recapitalizations in middle market companies appears strong in sectors that are still growing.   Leveraged dividends are also alternatives for those needing liquidity.

Deals will continue to get done.

Outside of the private capital realm, strategic buyers and foreign buyers remain active in consolidating industries that are not impacted by the banking crisis. The pendulum has shifted, and these buyers welcome the change of conditions.

How We Can Help

Cascadia Capital takes a long term approach to our clients corporate finance challenges, which includes advice and counsel well in advance of a transaction.  We are experts in raising capital and advising our clients in M&A transactions across a broad range of middle market industries.   At Cascadia Capital, we understand what options are available today and how to implement them.

We would welcome the opportunity to learn about your company and objectives and help you understand how the current market environment may impact your business.


Cascadia Capital, LLC is a national investment bank based in Seattle