noseFor those of you who are consistent followers of my blog, you might recall earlier this year I was rather sanguine (on a relative basis) with respect to the prospects for the pet industry in 2013. My thesis was based upon three factors. First, that a tepid recovery would result in slower pet population growth and the waning of the pet food upgrade cycle. Second, that slowing comp (same-store-sales) growth at PetSmart was in fact a proxy for the industry. Finally, that declining influence of the baby boomers, who have slowed pet replacement, would not be sufficiently supplanted by the necessarily levels of spending growth by Gen X/Y to propel the industry forward at projected levels.

As we round the final turn in the calendar year and head for home, things have not played out quite as I had expected.  The industry has proven itself to again be resilient and more adaptable than even I recognized. The economic recovery has been aided by strong equity returns and rising home prices that have exceeded most pundits expectations. Notably, this has resulted in solid growth in industry related personal consumption expenditures that indicate the industry should deliver projected 2013 results. While PetSmart comps are in fact slowing, management has found ways to adapt — prolonging the pet food upgrade cycle through expanding offerings and more square footage dedicated to the premium aisle, resetting key categories such as canine hardgoods, and evolving service offerings to be more compelling.  Management also reported their belief that the company’s online strategy is producing above market returns. Finally, pet adoption rates, a key driver of spend, have accelerated in 1H2013 adding additional reason for optimism. While there may be clouds on the horizon, rain does not appear imminent. As such, we expect the industry to hit its annual growth projections.

In addition to strong growth, we are also predicting that 2013 be a good year for industry related transactions, both M&A and private placements. One of the best predictors of future M&A volume is trailing private placement volume. Generally speaking, private and growth equity firms have three to five year hold periods. From 2010 – 2012 private placement volume met or exceeded M&A volume in the pet industry. Investments made in 2010 are now starting to come into season. Given the number of companies that will enter their exit window over the next two years we expect transaction velocity to continue to grow. Consumables, distribution, and hardgoods are expected to lead the way. Based on 2013 private placement volume we expect this to become a long-term trend.

The year has also produced a number of trends that we expect will have long term implications. Among these, we are seeing acquisition rationales of large strategic acquirers focus on the value of acquired brands in the pet specialty channel. As an example, when Del Monte Foods acquired Natural Balance Pet Foods, it was the latest in a long line of wellness oriented pet properties snapped up by a large strategic acquirer. Historically, these acquired brands have migrated out of pet specialty and into mass where the market opportunity is perceived to be greater. Our understanding is that Del Monte intends to keep Natural Balance in its current channel. Sure we have heard this before from other buyers, but if you consider that mass is losing sales to pet specialty and currently there is a lack of large brands in independent pet specialty with traffic pull, we may be reaching the tipping point where taking share in broader pet specialty is the more attractive opportunity. Increasingly, we see large strategics seeking ways to connect with a premium consumer in pet specialty and believe that acquisition rationales will increasingly rely on this inherent logic.

Additionally, we are seeing a proliferation of direct-to-consumer models in the pet industry. While ecommerce is the most well known business model for direct sales to consumers, a number of alternative models (flash sales, curated retail, marketplace) have emerged post-recession. During the past twenty-four months, companies promoting these models have begun targeting the pet space.  Notably, Bark & Co. (curated retail), Dog Vacay (marketplace), and A Place for Rover (marketplace), have all raised significant amounts of capital. What these companies, and their backers, are betting on is that as Gen X/Y, demographics that have grown up transacting online, ascend in purchasing power these models will see increasing adoption.

As always, a more complete exploration of these topics and the broader industry are available in my report (post here or email me to request a copy).


During the second half of 2011, the pet industry endured a brief hiatus from its uninterrupted growth trajectory.  Against a backdrop of macroeconomic uncertainty, the pet industry suffered as consumer sentiment deteriorated.  Stagnant unemployment, coupled with a housing market laboring to recover, left the industry with a post-holiday hangover.   As a result, expectations for 2012 were modest given the industry was in transition as historical growth themes from the 2007 – 2010 period waned.  This commentary was front and center in our Spring 2012 report.  What we did not accurately predict was how quickly Humpty Dumpty would be put back together again.

As we approach the bell lap for 2013, the pet industry appears poised to beat expectations for the year.  Pet population growth has accelerated, the housing market has improved, and consumer sentiment is trending up and to the right again.  This has been good for the pet industry, which saw both revenue and earnings accelerate. Coupled with investments in innovation and further evidence of traction for the Total Pet Health trend, the near term outlook looks much brighter today. Below is a summary of the macro trends I see currently impacting the industry.

  • Industry in Major Innovation Push. In recent versions of my report, I expressed a belief that the pet industry was laboring through a period characterized by a lack of innovation.  Limited investment during the recession resulted in fewer new product introductions in 2010 and 2011.  While the 2012 tradeshow season did not produce evidence of breakthrough renewal, there are signs the industry is addressing the issue.  Product company CEOs tell me they are investing heavily in R&D, retailers are promoting innovation through launch support, and equity backers are funding unique start-ups.  Where there is innovation there will be further consolidation.  Expect more excitement at Global Pet Expo 2013.
  • Ecommerce Gaining Momentum. One of the most discussed topics at SuperZoo was direct-to-consumer for the pet industry.  There is evidence, based on web traffic patterns, and partner engagement, that the category is moving online and that ecommerce leaders are growing rapidly. As Amazon experiments with same day delivery and online retailers find partnerships that provide access to pet prescriptions, we expect this solution set to grow in acceptance, taking share of independent pet specialty stores. Notably, PetSmart, who has commented that they are not seeing any market share erosion from online competitors, recently changed their management bonus program to tie ecommerce sales to compensation; recognition by the industry’s top retailer that ecommerce is a real competitive threat in pets over the long term.
  • Public Pet Companies Breakout, Again.  During 2H2011, core publicly traded pet companies lost momentum. Lacking a cohesive growth driver, earnings contracted and pet equities traded on company fundamentals with mixed results.  The industry malaise did not last long, as our comp group collectively produced 12.1% revenue growth and 16.7% earning growth in 1H2012.  As a result, core pet equities, as a group, have outperformed the S&P500 by over 15% in 2012.   While the expected names (PetSmart and MWI Veterinary Supply) continue to perform, it’s notable that others, such as Neogen Corp (23.7% equity return), Central Garden & Pet (40.4%) and Oil Dri Corp (11.2%), which have lagged in prior periods, have all produce double digit returns.  The broad advance is, in my opinion, a very positive sign for the industry.
  • Big Deal Potential.  Headline deals are important influencers of transaction dynamics within an industry.  Deals beget deals, as buyers and investors look to take advantage of market shifts caused by consolidation. While the pet industry has enjoyed a number of high profile transactions over past 24 months, these deals have been spaced in such a manner so as to limit our ability to glean anything meaningful from the associated transaction multiples. A single data point is not indicative of a trend.  However, when multiple deals express the same characteristics, it has a powerful impact.  With the recent Sergeant’s  Pet Care Products transaction, the pending Zoetis (Pfizer Animal Health) IPO, and potential deals for Central Garden & Pet / Blue Buffalo / Natural Balance Pet Foods, the industry may have a run that re-frames market valuation dynamics, similar to 2006 when the revenue multiples for premium consumable companies were established through the Milk Bone and Meow Mix transactions.

While we have never soured on the long term potential for the pet industry, what we are seeing in terms of a recovery and re-acceleration is remarkable.  It is our expectation that 2012 will turn out to have been better than expected, providing the industry an opportunity to breach its prior apex within the coming years.

As always, a full copy of my report is available by email.


Normally I wait until after SuperZoo to publish an update to my biannual, but there has been too much noteworthy happenings since my update in January to delay it any longer.   As always if you want the full report, feel free to post here or email me.   I think this is the best report yet, and with each iteration, and your feedback, it continues to improve.    So now on with it.

The pet industry continues to be a star performer along the consumer landscape.   While growth rates have been moderating (given that the industry is tied to the macroeconomic environment and housing market conditions this should be no surprise) the pet industry should produce growth that doubles domestic GDP expansion in 2010; not many industries will be able to make the same claim.  Further, I expect the majority of that growth to be driven by increase spend, as opposed to an expanding pet population.

As you might expect, given the positive forecast for growth, public equities of pet related companies have outperformed the S&P 500 in 2010 by approximately 4%.  Of significance, earnings for my sector index showed year-over-year growth in the second quarter.   This should set up the comp group for a strong full year from an earnings growth perspective due to the easy comp quarters ahead, resulting from the full weight of the recession.  As earnings go, so do prevailing equity prices.

Among the strongest reporters of earning growth within the industry was PetSmart.  The company beat estimates, raised full year projections, and even outcomped Wal-Mart Stores (“Wal-Mart”) on a same-store sales basis through the first half of 2010.   Also notable was the performance by category, which showed a decline in consumables, likely resulting from food price deflation,  but an improvement in hardgoods (two positive comp quarters).  Services continue to grow, albeit at a slower pace.   Live Goods continues to contract, which may be a harbinger of things to come, or may simply be a shift towards adoption and smaller breeders as a result of negative publicity.

Of equal importance are pending changes to PetSmart’s merchandising strategy.  In October 2009, PetSmart agreed to partner with Martha Stewart on an exclusive line of pet products.  Martha Stewart PetsTM launched on June 30th with 160 SKUs and has been, according to management, favorably received by customers in the opening weeks.  This fall, PetSmart will rollout a co-branded consumables line of vitamins and supplements in partnership with GNC Corp.   PetSmart expects these partnerships to drive store traffic, comp transactions and gross margin.  If successful, they will meaningfully influence how major pet retailers merchandise in the future.

The transaction market for pet related properties continues to improve and shows signs of resilience.   As an example, we believe the Natura transaction took place at multiples that were in-line with the Berwind Corporation/Old Mother Hubbard, Inc. deal, which would mean that multiples on major properties are essentially unchanged from 2008.  The independent pet specialty space continues to see high levels of M&A activity as well as investment; a trend we don’t see changing.  Further, a number of equity firms with whom we have regular contact are in fact ramping up their efforts in the pet industry.  Some of the most notable deals in 2010 are summarized below.

Private placements within the industry have also been robust in 2010 as well, with Animal Supply, Champion Pet Food (makers of Orijen), Phillips Feed Service, Petra Pet and Strategic Pharmaceutical Solutions (d/b/a VetSource) all successfully placing equity for growth or recapitalization.

Of all the deals that have been done, M&A or otherwise, none are of greater importance, in my opinion than Natura Pet Products/Procter & Gamble (“P&G”).   This is a transaction for the ages, and one that reverses a number of prevailing assumptions and sets off a litany of questions.  Most notably, the market had long been expecting P&G to exit the pet space, putting Iams in play.  Instead, the company doubled down and immediately positioned itself as a leading provider of natural pet food products.

The transaction has implications for P&G vs. other major pet players, PetSmart vs. Wal-Mart, and mass channel vs. independent pet specialty.  Its no secret that I expect for Natura brands to be in the mass channel in 2011.   After all, Wal-Mart is P&G’s biggest customer, but the company has a relationship with other major pet retailers.  Additionally, I anticipate it will spur additional investment and M&A in the food category.

Regardless of what happens during the balance of 2010, the pet industry will have had an exciting year.   The industry continues to evolve and improve, for the benefit of pet owners and industry participants.









There is a growing belief – and it’s slowly being supported by market data – that the economy is improving. Traditionally, we would take this to mean that key indicators are accelerating; and, in some cases, such as manufacturing activity and worker productivity, they are. But the term “recovery” has also come to mean something akin to “not as bad as last time”; or, talking more like an economist, it’s become code for “a deceleration of the decline.”

So, whether we’re using lay language or professional parlance, we need to confront the fact that service sector activity, on which our economy is now largely based, continues to contract, and unemployment figures remain near historic highs. Both of these signposts should serve as a clear reminder that all is not well. And, despite professing that the current recession is “likely over,” Federal Reserve Chairman Ben Bernanke continues to urge caution with respect to the domestic economy.

If we move beyond the macro-indicators, there are also signs that a bottom in the transaction environment is imminent.

The most obvious key indicator is the public equity markets, where we have seen a very healthy recovery. The current bull market rally has driven the Dow Jones Industrial Average up 46%, the third-largest six-month rally in history. As a byproduct of the run-up, corporations have been able to pry open a new issuance window not seen in years. Further, credit spreads have tightened and issuance volumes of both investment grade and high yield debt will surpass 2008 figures. These have enabled corporations to access capital and much needed exits for financial investors, both of which are important to transaction velocity because liquidity drives the lifecycle.  In addition, CEO confidence, as measured by The Conference Board, surged in the second quarter into an “optimistic” reading. This means more views to the positive than to the negative. A favorable market outlook correlates strongly with corporate and financial buyer appetites.   Finally, there has been a spate of large deal announcements, driven primarily by large cap public companies seeking to capitalize on strategic synergies. These deals have changed the tone of the M&A market.

Based on available data, peak-to-trough contraction in M&A transaction volume has typically taken two years. The recessionary period of the late 1980s and the period at the outset of this century both conform to this pattern. As such, given that the current contraction began in late 2007, we would expect to see a bottom late this year. That said, we’ve seen improvements in market conditions, but we don’t believe circumstances are right for a quick return to normalcy for a number of reasons:

Sponsors on the Sidelines. While we have seen an increase in sponsor inquires regarding ongoing mandates, we have seen only a handful of term sheets and even fewer closed deals from this community. On the whole, the private equity industry is still struggling with problems within its existing portfolio. A lack of cheap debt capital to underwrite new deals has resulted in depressed sponsor-backed activity volumes. Year-to-date, global private equity activity is off over 66%, though.   The trailing four quarters have been slower than any four quarter period since the twelve months ended June 2002. Until sponsors are able to access cost-effective debt, total transaction volume will be muted.

Mezzanine Debt Not Solving the Last Mile Problem. Mezzanine debt was touted as the means through which leveraged buyouts were going to be effected when lenders scaled back on transaction leverage. It’s true that mezzanine fund-raising has reached unprecedented levels and subordinated debt has grown as a percentage of the deal capital structure, but company performance has declined significantly, rendering mezzanine of limited use for the buyout community. Further, lender return expectations have exceeded a level buyout professionals deem reasonable.  While mezzanine debt will be part of the solution during the recovery, company operating performance must improve in order for it to be accessed as intended.

Deal Velocity Absent in the Middle Market.  The composition of 2009 deal activity is heavily skewed toward transactions that are greater than $5 billion in value; but deal volume has dropped by approximately 23% in this segment. Even more telling, volume for deals involving companies valued at less than $1 billion (a traditional definition of the middle market) has fallen by over 50%. We’re seeing that most high-quality middle-market companies in the Pacific Northwest seem content to sit out the current market cycle. And deals that have gotten done, like RW Beck / SAIC, occurred at premium-market multiples that were justified by high levels of strategic value. The middle market makes up the largest percentage of transaction volume (33% in 2008); but until valuations improve, a true recovery in the transaction environment cannot be realized.

Strategic Buyers Continue to Show Caution.  While premiums paid for transactions in 2009 are well above the long-term historical average, this figure is skewed by a handful of large public deals. As an example, Dell offered a a 68% premium to the prior-day close to acquire technology services company Perot Systems. In reality, we are finding that strategic buyers are quite cautious with respect to tuck-in acquisitions. Most buyers views this as an opportune market to buy companies at cost-effective prices. But we don’t see these buyers stretching on valuation until operating results improve and financial buyers are able to provide a realistic alternative for sellers.

Ultimately, deal volume will return when the buyer’s ability to pay  and the seller’s expectations again converge. We now recognize that the market eroded so precipitously that a very large chasm was created; it’s also clear today that it will take time to build a solid and lasting bridge over that abyss. An improvement in the macro economy is definitely good for deal activity, but economic growth has to be reflected in the income statements of traditional middle market companies before we experience a return to normalized conditions.

dots2David Chen, founder of Equilibrium Capital Group, interviewed me with respect to my perspective on the Ben & Jerry’s transaction and what it means for sustainability companies raising money going forward.  Below is the substance interview.  It appears on David’s blog Conscience & Commerce™: Mission Driven Commerce. Equilibrium Capital Group and Cascadia Capital have joined forces to try and help mission driven organizations solve their funding challenges.

conscience & commerce:  grappling in the real world with capital market realities

a case example:  ben& jerry’s

in the area of sustainability, we find a set of entrepreneurs who were counter-culture rebels who went on to create a new type of business model that aligned their core values and aspirations with their business objectives and products.

one can argue that the success of these companies is the execution this set of core values and beliefs about sustainability into products, their internal business practices, and therefore into their brand.  in other words, every where you scratch in these companies, in their relations with partners, vendors, customer, you find consistency and authenticity.  the core values are so real, they are a decision support system for their employees.

the irony is that with success, even these firms need to deal with founder/owner transitions, expanding the shareholder base, shareholder liquidity, expansion capital, strengthening the balance sheet, and insuring long term access to capital.  yet paramount in these capital decisions and structures are those core values and aspirations.  even the words “exit & exit strategy” are antithetical to their objective: to create an enterprise that is both financially sustainable, but also a platform for impact and change. the traditional options don’t seem to fit:  selling out to a PE firm, selling to a strategic corporate buyer, IPO, or becoming a consolidator (and that begs the issue of capital access).

we have an opportunity to probe this topic with our good friend bryan jaffe from Cascadia Capital, a leading middle market investment bank with a focus on technology/media, sustainability, and renewable energy sectors. bryan brings deep industry and product expertise in the food industry.  in particular, we are interested in bryan’s perspective on Ben & Jerry’s sale to Unilever, executed by his prior employer Gordian Group, LLC.  in that transaction we learned first hand the need to ensure that capital and company share a common ethos and what it takes to protect the founders and corporate missions from traditional shareholder restrictions. how can you preserve and propagate the very values that created the success and the value in the brand.

Q?:  what was the compelling reason for considering this transaction?   where were founders ben & jerry during this transaction?

BRYAN: Ben & Jerry’s had both a great product and a loyal customer following, but it was an operationally challenged company.  It lacked the case volume or financial muscle to underwrite its own distribution system, which put them at a competitive disadvantage.  As the business matured, earnings growth did not keep pace with investor expectations, and the stock price languished.  There were also stumbles on the mission side of the business, which brought negative publicity.  Shareholders became restless and the directors began to feel the pressure associated with being fiduciaries.

The board brought in a new CEO and hired an investment banker to evaluate alternatives.  While a number of options were pursued, ultimately the market spoke and a strategic sale was deemed to be in the best interest of shareholders.  Unilever could solve the distribution problem.  While Ben and Jerry were both active in the business and influential board members, their voice became somewhat muted due to the public company governance structure.  Net net, the price Unilever was willing to pay was so high relative to the prevailing equity price that the board and founders were hamstrung.  It wasn’t any great secret that Ben and Jerry were opposed to the sale.  Jerry Greenfield’s recent interview in The Guardian confirms that he still has regrets despite the structure of the deal, which was designed to ensure continued adherence to the company’s mission.

Q?:  from where you stood, what were the core values and aspirations in this company?  what did ben & jerry’s stand for? what were the values in the brand? how much had changed with the departure of the founders, ben and jerry?

BRYAN: Ben & Jerry’s was the first real double bottom line company.  They took the concept of balancing social responsibility with economic responsibility to a new scale.  The brand stood for more than just great ice cream.  While they were interested in profitable growth, they felt they had a larger responsibility to the environment in which they operated.  The social mission was the enterprise mission and it drove the corporate, business and functional strategies for the business.  That customers remained loyal over time served to validate this operating model, since consumers were not wanton for choice in the category.

Ben & Jerry’s core values centered on a symbiosis with partners, employees and the community.  Ben and Jerry utilized their company platform to redistribute wealth and help partners who were also trying to achieve a social good.  Ben and Jerry, as individuals and as a collective, stood for a balanced ethic, creating harmony between self-interest and ones obligation to others.  It was a “yin and yang” between values and creating value.

Ben & Jerry’s has continued to perform under the Unilever ownership.  However, I believe some of the authenticity of the mission has been compromised.  At the very least some of the irreverence is gone, since you can’t play the David v. Goliath card anymore.  However, the erosion of the mission started before the sale, when the company was forced to modify its salary cap structure to attract professional management.  The public company ownership structure also undermined the mission.  Unilever continues to adhere to the tenets of the deal, but to them it is a business.  They haven’t expanded the mission beyond their contractual obligations. The question is what will change if the business under performs.  A deep consumer recession may test that theory.

Q?:  what did each party think they were buying or selling?  what were the differences in the ethos?

BRYAN: Unilever was buying a brand and the opportunity to exploit that brand with their distribution and branding muscle.  They approached the transaction from a traditional public company ethos – the ability to accrete earnings and therefore drive value for their shareholders.  Unilever took on the social responsibility aspect as a means to get access to the brand; it was part of the purchase price so to speak.  At the same time, they believed that owning Ben & Jerry’s would enhance the perception among consumers that they were socially emancipated on some level.   You will note that Unilever now features a “values” section on their homepage, which includes addressing environmental and social concerns.

Ben & Jerry’s thought it was buying a solution to their distribution challenges and a means to perpetuate the social mission of the business.  Unilever convinced Ben and Jerry that this was an opportunity to grow the company’s social commitment.   The difference in ethos was evidenced in the structure of the deal.  If this was a marriage of like minded enterprises Unilever would not have had to take the steps they did to convince stakeholders their interest was authentic and their intentions were pure.   On its face, some people might wrongly conclude that at a high enough price, the social ethos could be made malleable, but that was not the case.

Q?:  what happened after this transaction? and with your “evolved” insights on sustainability, what would you have done differently?

BRYAN: For the most part it appears that Unilever has lived up to their end of the bargain contractually – “letter of the law”.  But again, Ben & Jerry’s has performed for them as an asset, so there was not a substantial incentive to deviate from that strategy.  However, they have done little, if anything, to expand the mission of Ben & Jerry’s.  That is where people should be disappointed.  In 2005, Walt Freese, CEO, acknowledged some softening of adherence to the company’s true mission.  What is interesting is that some a smart such branding organization would not see this as undermining the brand.

With respect to what I would have done differently, in short I would have never taken the company public, not on the terms that were implemented.  At the very least, I would have established two classes of common and kept voting with respect to a change of control in the hands of the founders. That was a viable option at that time.  I’m not sure that is true to today.  Additionally, I would have kept the board small so as to limit dilution of the founders influence.  Ben & Jerry’s had a large unwieldy board.  That all being said, I think ultimately there was not an appropriate construct available to raise the monies necessary to grow the business while fully insuring adherence to the mission.  This is why you haven’t seen more double bottom line companies go public.  A new solution must emerge for this class of companies.

Q?:  what new framework would you apply to these unique mission balanced firms as they consider the issues of founder/owner transition and shareholder liquidity?

BRYAN: Over the past five years we have seen health and wellness and sustainability emerge as investable categories and pools of capital have been raised to fund companies with missions that fit within these industries.  At the highest level, the market is moving in the right direction.  Yet, firms like DBL Capital and TBL Capital don’t have access to the funds necessary to help larger sustainable companies reach the next level.  They are also seeking venture like returns and institutional governance structures.  This does not work for many mission based organizations.

It is my view that today there are pools of capital, outside the institutional context, that would invest in later stage sustainable businesses without receiving the rights afforded to shareholders of public companies or venture capital/private equity firms.  Eventually, I think there will be institutional funds that fund later stage deals on these same terms that emerge as well.  However, more success stories are necessary before that happens at scale.  The question is through what means to organize the existing pools of capital, how to match buyers and sellers and what rights to offer each side to clear the market.   At the base level, you have to consistency of ethos between issuers and investors.

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