Lower checks, better deals mark buyout scene

A clear trend is developing in the world of sponsored buyouts when it comes to the amount of equity firms are contributing. Equity checks by PE firms are going lower. This movement should set the stage for more M&A activity and provide the potential for larger deals than have been seen over the past few years, according to industry experts. While the number of M&A deals may not have taken off, the year could still be a big one considering the lower equity required and continued ease of borrowing.

In 2012, the average equity contribution by PE sponsors in leveraged buyouts was 39.4%, the lowest since 2007 when the average was 32.9%, according to figures from Standard & Poor's LCD. The number hit 41.5% in 2011 and 43.8% in 2010.

The fourth quarter of 2012 was slightly lower than the year as a whole, clocking in at 39%, and that number could be headed even lower.

The market has shown it is willing to digest much larger deals than it has since the LBO boom ended and at lower equity checks. Berkshire Hathaway Inc. and 3G Capital announced in February that they have agreed to purchase H.J. Heinz Co. for $28 billion. In another blockbuster deal, Silver Lake and Microsoft Corp. agreed to team up with Dell Inc.'s founder to take the company private in a $24.4 billion deal.

The Dell deal, with its 24% equity, in particular is symbolic of where equity checks are headed. That figure is almost 15% below the average amount of equity seen in deals last year though it is fairly typical for big name deals, said Jorge Mora, head of Macquarie Group's U.S. Financial Sponsors Group.

"Those statistics blend all LBO activity, from small to large deals and I think that skews the data," Mora noted. "When it comes to the large headline deals, the reality is that the equity contribution can be significantly lower than that."

Michael Chernick, a partner at Paul Hastings LLP, agrees. Still, he said, most deals seem to be getting done at rates lower than the average for 2012 right now. "I'm seeing it settle in the 25% to 30% range," Chernick said. "I've seen some outliers, but I think those deals are more special situations."

Chernick noted one deal done recently with an equity check of slightly below 25% but said it is still too early to say that is a trend. "I think there may be room to go slightly lower, but I don't see it going down to levels of 2007 where there were big deals with 15%," Chernick said.

One of the lowest equity-financed deals in 2012 was the DuPont Performance Coatings sale to Carlyle Group, according to data provided by Macquarie. The $2 billion deal required an equity check of just 21%. The $1.7 billion Apex Tool Group LLC acquisition by Bain Capital LLC saw an equity check of 23%. Leverage for these deals was 5.6 times and 5.4 times, respectively.

The lower equity check has translated to higher leverage ratios, too. However, the leverage ratios seem to have risen more quickly than the equity checks have dropped.

Alliant Insurance Services Inc.'s $1.8 billion buyout by Kohlberg Kravis Roberts & Co. LP touched the 7 times leverage level while a handful of other deals were close to that, including Carlyle's $3.5 billion acquisition of Hamilton Sundstrand, which was levered at 6.9 times, and Advent International's $3 billion purchase of AOT Bedding Super Holdings LLC, which came in with a 6.7 times leverage ratio.

Mora said that while leverage multiples have reached 2006-2007 levels, minimum equity contributions have not fallen quite as far.

So how low can equity contributions realistically go? The answer is complex. Debt is still cheap, and investors are still anxious to get their hands on what yield is available. If M&A activity picks up, which would likely be in part due to lower equity checks and cheap debt, the amount of equity required could nonetheless remain higher than anticipated as companies battle to put up the best offering.

"Even though it has cooled a bit, it's still a very, very hot debt market," Mora explained. "If that continues, we should see continued pressure to lower equity contributions, but that's countered by another macro factor: a lot of competition for good assets. The minimum required equity check by the banks may come down further but competition could still keep equity contributions at current or higher levels."

Sponsor-backed M&A has yet to return to the levels seen in 2006 and 2007, though. During those years, private equity deals averaged 23% of all M&A activity, according to data from Macquarie. Last year, the number was 17%. At the same time, sponsors have $946 billion of dry powder that could be deployed, which is actually more than was available in 2006, when sponsors had just $801 million of available capital.

The bottom line for investors is whether they are getting enough out of the money they have invested. So far, the answer is yes for both debtholders and private equity firms when it comes to LBOs. As long as default rates remain low, the answer will continue to be yes.

All signs point to the low default rate continuing. As of the end of February, only five companies had defaulted for a total of $1.5 billion, according to JPMorgan Chase & Co.'s Default Monitor. By this time last year, nine companies had seen defaults totaling $3.3 billion. So there's no reason for debt providers to stop providing cheap debt because the banks will be able to move the debt as quickly as they can write it.

"The banks that are underwriting it don't want to hold that paper on their books, but the fact is that they have the confidence to underwrite because they believe they can distribute the paper. The cash that is available in the debt market is massive," Mora said.

And despite lower equity investments and higher leverage, Mora said that LBOs have ended up as good investments for the companies buying the debt due to low default rates, especially on the PE side.

"Private equity-owned companies have a lower rate of default than non-PE-owned companies that are overleveraged. Lenders should be pretty happy with the performance of sponsor-led LBOs during the downturn."