Middle-market investment bank powerhouse Houlihan, Lokey, Howard & Zukin Inc. may have headquarters in Los Angeles, but its Minneapolis-based operations are far more important to the firm than some mere provincial outpost.

That's largely because of Jeffrey Werbalowsky, Houlihan's co-chief executive and global co-director of its restructuring practice. About 14 years back, Werbalowsky and his wife, a Minneapolis native, decided Los Angeles was no place to raise their three kids and that Minnesota was where they wanted to be. Houlihan didn't have a Minneapolis office, so Werbalowsky created one.

"It's a great place to be. I've never regretted it for a second," says Werbalowsky, in his typical ebullient way. "Life is balance, and it's easier to balance here in Minneapolis than other places I've been."

Among other benefits: Werbalowsky, an extraordinarily fit 51, can bike to work from his home in nearby Edina when the weather allows it.

The office now boasts about 20 professionals and includes restructuring, corporate finance and valuation. Werbalowsky is the office's senior managing director. He co-founded the firm's restructuring practice in 1988.

Scott Richardson, 37, is a managing director and looks after middle-market M&A in the Midwest. He joined Houlihan Lokey in 2004 from rival Minneapolis firm Goldsmith Agio Helms (now Lazard Middle Market). Richardson moved to Minnesota about 15 years ago; his wife is from the state. "Minnesota was part of Canada, as far as I knew," he says. He has also become a hard-core convert.

Werbalowsky and Richardson sat down recently with The Deal's Matt Miller to talk about the Midwest, its middle-market deal flow, its restructuring environment and life there in general.

The Deal: Does it matter being based here?

Jeffrey Werbalowsky: It does. ... Over the last 14 years, we've worked on a lot of deals in California, obviously a lot in Manhattan, but in South Carolina, in Chicago, Wisconsin, Texas. Minneapolis is a convenient, centrally located place to access all the places in the country -- you can fly out in the morning and be back that night. It's also not a bad gateway to Europe and Asia. Net, net, probably the best place to do restructuring is Manhattan, but other than that, I think this is a good compromise for us.

In terms of industries, where will you see restructuring this cycle?

Werbalowsky: For many reasons, over the next distress cycle, there will be a shift away from large cars. That has to translate into pain for both the auto companies and their parts suppliers. ... I think commercial real estate across the country will be under a huge amount of pressure. There will be a lot of restructurings in real estate. ...We are way too much a consumer-driven society. ... Over the next cycle, we will cut back on our consumption, and that will create substantial pressure on all types of retail.

Are there more Midwestern companies restructuring?

Werbalowsky: There are a lot of manufacturing companies over time that have restructured in the Midwest. But I'd say, on the margins, we see less restructuring in the Midwest than other parts of the country. It may be because they're just less aggressively leveraged. It's that conservative Midwest mentality. ... You'll see a big shakeout in ethanol production. And that's much more a Midwest phenomenon. That's where the crops are.

We've seen several busted leveraged buyouts recently. We haven't heard as much about deals that closed. Are they in trouble?

Werbalowsky: They're under water on day one from a valuation perspective. But that doesn't mean they'll default right away because, from a cash-flow prospective, a lot of these deals have built in enough flexibility that they can survive. People [say], "You won't really have restructurings because you have toggles, you have PIKs, you have resets, you have covenant lights." And I say, "Absolutely, that's all true." But in many cases all that will do is postpone the day of reckoning. A lot of these companies have taken on too much debt because they could. It was absolutely rational for buyout firms to say, "Let's leverage up with every penny we could because we'll need it." You'll see a lot of buyout deals going bad -- even with all the covenant-lite and all the PIKs and toggles, they'll run out of money.

Will restructuring out of court become a lot more problematic?

Werbalowsky: It depends. I've seen, even in this difficult financing market, lenders say to underwater equity sponsors, "You know what, we'll work with you," because in every restructuring, people compare, rightly or wrongly, what they could get by doing consensual deals with what they could get by pushing a company into bankruptcy or doing something nonconsensually. In many cases, lenders say, "I can't do any better. I could force this good equity sponsor out, but what good is that to me? I can't basically create more value."

You'll see a mixed bag. There will be out-of-court restructuring. They'll be consensual deals. But the simpler the capital structure, the more likely you'll get consensual. When you have complex capital structures, with junior and senior creditors, it will be very difficult to strike the right balance of pain sharing.

What about the prognosis in general for middle-market companies in the Midwest?

Scott Richardson: To be midmarket-sized companies based in the Midwest and still be around and thriving beyond just having survived the globalization and outsourcing that took place [means] they must have a demonstrable niche that they've carved out, whether it's a proprietary product, speed to market, the size of the niche. ... From an entrepreneurial standpoint, the Midwest is a little more conservative than either of the coasts. For even the really good companies, their customers just aren't doing as much business.

In general, for middle-market manufacturing and service companies, if they survived to this point, they found their niche.

While they may not be growing at double-digit rates as they did over the course of the past three, four, five years, for the most part, those companies are still doing very well.

What do you see developing in midmarket dealflow in the Midwest?

Richardson: The big dynamic that we're seeing over the last two months in family-owned businesses are [entrepreneurs] saying, "You know what? We've had an awfully good run, and we think the tax rates are going to change." With a possible increase in capital gains a catalyst, we've seen a lot of folks coming to us wanting to talk about potentially selling their companies ahead of the end of the year. Capital gains increases of 10 to 15% on a $200 million deal are absolutely meaningful, even if the multiple is a half-turn or a turn less than it had been. You wait for that turn to come back in a more robust M&A market, and you're still going to be net down on an after-tax basis. At the end of the day, family-owned businesses don't value IRRs [internal rates of returns] the way private equity groups do. It's cash returns to the bank account.

Because the nature of our client base here in the Midwest is less institutional and more family owned, getting the last dollar for your business and having that business fail after the fact is a taint on your family's legacy. They look at it and say, "Sure, I would have loved to get $500 million instead of $350 million, but the market is $350 million and even getting $400 million would have put the business in jeopardy."

The private equity guys are being more cautious. We're seeing less activity there than its peak the middle of last year, but ... here in the Midwest in particular, the group that I oversee, we're actually busier than we've ever been.

Do those tend to be manufacturers?

Richardson: The mix is fairly representative of our group. We have a tremendous niche advisory in steel-related businesses, and given the cost of steel, there's still a tremendous activity there on the manufacturing side. Here in the Midwest, manufacturers [produce] somewhat higher-edge products, maybe not cutting-edge technology, but relying on a lot of the technology in and around processing. You'd never imagine there's this phenomenal family-owned company in the Midwest that is actually growing 10%, 15%, 20% a year even in these markets. Their manufacturing is very engineering-enabled as opposed to mass-producing widgets. The number of private businesses that you've never heard of that are worth $100 million, $200 million, $500 million is extraordinary.

As you look at the Midwest as flyover country, you do think of the Midwest a little bit as Detroit and downtrodden.

For the most part, it couldn't be further from the truth.

You tend to represent the sell side. Who are your buyers?

Richardson: The strategic buyers are still there. ... The economy may be on the verge of a recession, if it isn't already in one, but the cash that large strategic buyers have is extraordinary. The strategic buyers need growth. As the growth of their underlying operations or their underlying business units is slower due to the recession and acquisitions are available and attractive, they're able to buy on relatively high multiples, but maybe a little less than six months ago, when private equity firms were beating them out on deals. Those are deals that they'll want to do.

Right now we're cautioning our clients that going to market and trying to sell a deal predicated on the credit markets is a very risky proposition, given the uncertainty.

What about the typical multiple here? Are you seeing it fall?

Richardson: Because it didn't expand as much as a lot of the sexier, nonmanufacturing industries, it had less to fall. If you have a company in a demonstrable niche, a leading market share, and the business is growing, you will still get a very, very attractive multiple. We just met with a company that manufactures in the Midwest, near Chicago. That company will probably trade at a 9 times multiple. They have proprietary products in a niche that's growing at double-digit rates. If it's a manufacturer that's growing at 3%, 4% a year, then you're looking at 6 to 7 times.

There was a time not too long ago, in 2001, 2002, a middle-market manufacturing business may have only sold at 5. That would have been the norm, and 6 would have been extraordinary. Now 6 would be at the lower end of a good manufacturing company.