Cross Keys Capital

In the aftermath of the credit crisis we have witnessed business for private equity groups come to a halt. In the first half of this year, only $24 billion in deals were completed worldwide, compared to $131 billion and $528 billion in deal volume in 2008 and 2007, respectively.

It looks like now the outlook for private equity may have just reached a turning point. According to a Goldman Sachs report A perfect storm for M&A “The private equity industry is starting to see some positive signs, serving as an incremental tailwind for this M&A cycle. While capital raising conditions remain difficult, we are encouraged by several factors, including significant ‘dry powder’, improving capital market conditions, a pickup in realizations and rising opportunities for returns, which further support our favorable stance on M&A.”

One of the hardest aspects for private equity business has been the availability of financing; the high cost of borrowing and the increase in credit standards for PE loans have substantially affected the M&A business. Another reason why PE firms were deterred from doing deals in the months following the credit crisis was due to the fact that they had stacked their portfolios when business was roaring in 2007. Many of these firms are basically trying to nurture these firms that they have invested in and make sure that they survive the remainder of the downturn in the US economy. Currently, PE firms are sitting on a lot of cash and are analyzing potential targets for the end of this year and into 2010.

“On the sell side there have been some distressed sellers, and those seem to be the deals that have been getting done.  Going forward I think that we’ll see an uptick in the number of private equity deals getting done.  I think that it will turn into somewhat of a seller’s market as the buyers become more aggressive after sitting on the sideline for so long” stated Cross Keys Capital Associate, Robert Athas.

Cross Keys has recently experienced some loosening in the commercial credit markets with regard to its own engagements. Senior debt, as well as mezzanine financing, has been committed to deals allowing for PE funds to come off the sidelines.

One tactic that PE firms will use in the months to come is to take opportunities to invest in underpriced companies even if it forces firms to look at new industries that are different from past strategic focuses. “We expect PEs may need to be flexible — both in structure and sector. There is more willingness to look at investment opportunities beyond the traditional sectors and structures,” noted Michael Bracken, a managing director at Royal Bank of Scotland at the World Knowledge Forum in Seoul this past week.

“What may drive their investment focus may more often be what is available.”

As the Market approaches year end, mergers and acquisitions appear to be gaining a glimpse of the proverbial ‘light at the end of the tunnel.’  With the recent spate of deals brought forth by behemoths such as Cisco, Kraft, Disney and Emerson many pundits are agreeing upon signs of economic convalescence.

Many small- and mid-cap companies have survived through the economic recession with the scars to prove it and now stand with weaker balance sheets and lower market capitalizations.  These types of underpriced companies have become takeover targets for larger strategic players with enough excess cash to attack a market ripe for acquisitions.

“In this context of global economic slowdown, the strategic benefit of M&A, which allows buying companies to achieve economies of scale and refocus their business model on key growing markets, is even more compelling,” said Gilles Cassagnaud, head of research at Mint Equities.

For these companies with excess cash to spend, such as Cisco, which has $35 billion as of July 25, 2009 on its balance sheet, this current environment yields a great opportunity for them to strategically buyout underpriced companies struggling to sustain growth and increase market share. By a strategic buyout or placement we imply a close alignment of markets served, technologies owned, research and development trends, financial position (revenues, market share) between the companies involved.

“Over the last few months we have seen a real uptick in both the number of deals coming to market as well the quality of potential transactions. Clearly, there is not the fear that the world is coming to an end anymore” noted Cross Keys Capital’s Managing Director, David Burns. 

Many experts believe that the increasing number of M&A transactions is a positive sign for our economy, but the strongest indicator will lie with the number of transactions that trickle down to strengthen lower middle-market activity and transactions. “We believe the recent upturn in merger and acquisition activity may be a sign that the improvement in the economy and credit markets has been sufficient to restore enough confidence to lift business spending,” stated LPL Financial’s chief market strategist Jeffrey Kleintop in a recent note to investors.

As transaction interest continues to spread we will be keeping an eye on which companies are coming off the sidelines to take part in this growth trend through M&A while also monitoring closely which industries are seeing the most significant increase in the number of transactions.

A year or two ago, it seemed that roughly eight out of 10 deals were bought by private equity.  Literally, everyday you picked up the paper and some private equity group was buying a business.  Since about the fourth quarter of 2007 and through 2008, we’ve already seen it switch around as strategic acquirers are much more active.

Private equity now encompasses the entire deal spectrum.   There are micro cap private equity funds that have been raised to just do small deals. Then you have the middle market capital that does the kind of middle to larger middle market deals.  Then you’ve got the behemoth type KKR or Blackstone type funds that are doing a billion, $2 billion, $10 billion, $30 billion type deals.  So, the money is there, but because they have pulled back in terms of pricing and things like that, it’s made it so that the strategic investor, (i.e. a competitor or another company within the same industry as the seller), are now back on a level playing field.

It’s almost like there was a pent-up demand by strategic acquirers to do deals and they were just being outbid by private equity guys.  Now that the private equity guys have pulled back, the strategic buyer feels this is a good time for them.  They don’t need to leverage their deals to the hilt as they can pay with cash or with a little debt financing and they are eager to get deals done.”

In the middle market, capital tends to be fairly steady.  The banks still tend to lend to quality local companies.  Buyers that come in to buy those quality local companies, tend to bring a lot of their own relationships with respect to the debt financing.  This would tend to preclude a real, fundamental change regarding how the middle markets access capital over the next 12, 24 or whatever the time period is.  However, what you might see change is the amount of leverage or the amount of debt that is available to get a deal done.

The buyer will probably need more “skin in the game” putting in perhaps 30, 40, maybe 50% equity and borrowing the balance vs only putting in 10% and borrowing 90%.

Perhaps an example would highlight this best… let’s assume that a company was going to be bought and a private equity group came in and said, “Okay, we need to go find some debt” and they went to ABCXYZ Bank.  Maybe two years ago ABCXYZ would have loaned $5 million or $10 million on that business.  Today, they may say, “Look, we’re only willing to loan three, or five, or seven.”  The amount that they’re willing to loan has probably dropped by somewhere between 20 and 30 percent.

So while the access to cash is relatively stable, the ability and how much a buyer is actually going to be able to borrow and how much capital they find is probably slightly smaller than it was a year or two ago.

The one thing about the middle market, in the space that we tend to do much of our deals, is that you usually don’t have the really high highs or really low lows like you do in the mega-merger deal market.   In the mid-market space, those deals are small enough to avoid some of the external challenges the big huge deals face like the impacts of Congress or the FTC, that can unpredictably alter the business landscape and their access to significant amounts of capital.  Thus, as the old saying goes, the greater the risk, the greater the reward and when the times are good, those deals get done and everyone reads about them but when the economy heads south, so do those mega deals.

The impact of the credit meltdown is something that is being very hotly debated from Wall St. to Main St. these days.  So, naturally the question should be how will this impact the Investment Banking world?

Some people say, “when the credit markets come back, everything will go back to normal.”  The real issue then is to ask what is “normal”?  Clearly in an ever changing market, what was normal two years ago probably was not the norm say four years ago.

Perhaps the best forecast for the industry is one that goes way back to the core of Investment Banking, the real “blocking & tackling” basics when buyers had to have a certain level of equity in the deal and they really had to understand the business model.  The days of speculative buying of multiple companies on leverage, without really understanding the business or the prospects for those business, are probably going to be absent for quite a while.  Relatively speaking, over the last 15+ years cash, has been historically very cheap.  Thus, the low cost of capital essentially emboldened speculative buying.

Now with the credit markets clamping down, private equity is going to become much more overbearing in the amount of due diligence they’ve done.  But deals will continue to get done.

Those professionals that have been in the industry for a long period of time have seen the ebbs and flows, the highs, the lows, the good times and the bad times, and this experience gives them the ability to step back and refocus around the core deal dynamics. This will include things like stronger financial statements or more “skin in the game” with the buyer putting in perhaps 30, 40, maybe 50% equity and borrowing the balance vs only putting in 10% and borrowing 90%.  If you have a solid well run company, there’s always going to be buyers who are interested, especially now, with large professional pools of money that are always on the lookout to buy solid growth companies.

To borrow from a couple of movie titles, we are more likely to go “Back to the Future” than to see an encore of the Wild West.

Most people in the country are aware that something is going on with the housing & credit markets. Even though selling companies or advising companies on the sale of a division isn’t really tied to the housing market, right now, the trends within investment banking are being driven by the credit markets.

This crisis is impacting both businesses for sale and potential acquirers specifically in their ability to borrow, make loans or get loans from some of the large financial institutions like Bank of America or JP Morgan or Wachovia.

Purchase Price

The biggest trend that we’re seeing now is that banks are unwilling to lend at the same leverage level that they were willing to lend say 6, 12, 18 months ago. What this means is that the private equity groups, and even the strategic acquirers, cannot borrow as much money to get deals done.

Thus, if they can’t borrow as much as they were previously able to, the price they are able to pay is not as great as it has been over the last 12 – 18 months. Hence, everything being equal, what companies are offering to pay for other companies is less.

Given that, the role of private equity has been shifting to accommodate this issue.

The Role of Private Equity

Another trend in the investment banking world is that private equity, the institutional pools of money, are still active buyers. However, they’re buying more judiciously. They’re doing more due diligence to make sure there are no surprises post-closing. They’re looking at every facet of the business to make sure that they understand it.

Whereas two years ago, private equity might had come in and said something to the effect that “we like the industry, and will worry about the specifics within that particular company later.”

Most of what might be called “the easy days” or “the low-hanging fruit of selling to a private equity group” are over. You have to have a company that’s very well-vetted. It’s got to have to have solid financials. It can’t have just a shoebox of information, which surprisingly got many deals done in the past.

Increased Quality of Seller’s Financial Statements

Given the increased scrutiny in the quality of the financial statements, it stands to reason that the next trend is toward having audited financial statements and stronger accounting information systems.

Probably the biggest issue we see currently is with buyers coming in and saying they just don’t think the financial records are of a quality they can trust. Either the company’s going to have to go out, and at their own expense have their financial statements audited or we’re probably not going to be able to do the deal.

In closing, the significant trends in the investment banking world are all somewhat related to the meltdown of the credit markets and companies’ inability to finance and leverage deals in the same fashion as they were a couple of years ago.