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The 100% solution

by Max Frumes | Published September 21, 2011 at 5:00 PM

This may not be as deep a crisis, but you can still dust off your 2008 leveraged finance playbook and turn to operation "zero leverage." Faced with harsh financing terms, private equity investors are considering closing pending buyouts by putting up to 100% equity with plans to finance later, say professionals familiar with recent negotiations. "It's one of the real benefits to sellers in working with large, well-capitalized buyers in today's market," says one buyout executive.

Believing that hikes beyond 200 basis points in extra-financing costs are temporary and hungry to close deals, larger firms are looking to put up to $1 billion in equity to secure a winning bid and possibly extract concessions from sellers that value certainty of close, say sources. It's a tactic that's recurred when large-cap targets seem inaccessible and megabuyout funds have money to put to work, potentially in smaller deals. With talks ongoing, investors did not name specific targets of all-equity deals.

"It's what I call the 'she stoops to conquer strategy,'/" says Houlihan Lokey Inc. financial sponsors banker Justin Abelow, who says the tactic has returned as an option after it was used from 2007 through 2009.

While many argue that recent debt market hiccups are not as troubling as those during the crisis, PE investors are revisiting 2008-vintage strategies, including minority investments or upping the amount of seller financing. "Whenever you've got a choppy leveraged finance market, sponsors start thinking along those lines," says Richard Farley, a partner at Paul Hastings LLP.

One thing that has not begun, however, is funds buying back debt of portfolio companies, mostly because prices of high-yield bonds and loans stabilized after falling in August.

Putting in all or mostly equity, or over-equitizing, might be the cheaper choice, given the alternative. Despite hints of a resurgence post-Labor Day, financing remains expensive, and new deals have been slow to emerge: For existing deals, banks officially launched lending packages for two larger buyouts, a downsized $1.325 billion financing for BJ's Wholesale Club Inc. and $800 million for Go Daddy Group Inc., along with deals of between $250 million and $500 million for buyouts of Garden Ridge Corp., Telx Group Inc. and Flexera Software Inc.

None of those included high yield, even though two small junk issuances priced to mixed receptions, and the market still awaits pricing of high-yield notes backing several buyouts larger than $1 billion, including the biggest U.S. buyout of the year -- Kinetic Concepts Inc. The circumstances where it could be the best option, dealmakers say, include either buying an add-on business for a portfolio company that another strategic is looking to purchase, or getting a jump on a competing financial bidder that would rely on debt financing to submit its bid.

One example of how a fund might execute such a strategy: In May 2009 Warburg Pincus paid $160 million in cash for an ice machine company ultimately named Scotsman Industries Inc. Manitowoc Co. was selling it to meet antitrust concerns from another acquisition. It wasn't until April 2010 that Scotsman launched a $145 million loan to finance a dividend to Warburg, says Standard & Poor's Leveraged Commentary & Data.

The wisdom of such a move can be questioned, says Jeff Golman, vice chairman of investment banking at Mesirow Financial Holdings Inc. "It can be a risky strategy unless the pricing on the deal is so compelling that it's worth the risks that may ensue." The obvious risk is that it takes longer than expected for credit markets to improve and the extra equity -- which should be earning 20% in most cases -- kills the returns. So even with the difficulties in high yield, senior debt financing is available, and there is an abundant supply of subordinated financing from funds looking for yield in a low-interest-rate environment.

Golman says in that case the equity contribution would move to 60% or 70%, instead of 40%. AEA Investors LP and a buyout group led by Kohlberg Kravis Roberts & Co. LP are putting in at least 50% equity for their respective buyouts of Garden Ridge and Go Daddy.

And don't forget appearances: A dividend recapitalization might not play out as well later in debt markets that have grown leery of buyout shops trying to load up a company with more debt soon after an acquisition. "It just looks bad," says Farley. "It's a better story to do acquisition financing with that debt."

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