Deep in the funk

More than a year since the liquidity crunch brought the leveraged buyout industry to a screeching halt, buyouts are still down, but not out. Until the markets froze in mid-September, a few large buyouts were squeezing through amid a dearth of financing, though not many. By contrast the middle market, with access to a wider array of financing sources, has stayed relatively active, while distressed investors have had their hands full with, well, distress, of which there is plenty.

But Wall Street's recent catastrophes, as dramatic as they are complex, have significantly deepened uncertainties. The impact is still roiling the credit markets, already struggling with tightened liquidity. The mood has shifted from frustration to a deep funk, leaving private equity's ability to finance all but the highest-quality or the smallest deals hanging in the balance. "Everybody is on pause, trying to assess the implications of this," says Mark Epley, Deutsche Bank AG's global head of financial sponsors.

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Lenders, besides scrambling to identify any exposure to bankrupt Lehman Brothers Holdings Inc., have been anxious to deleverage and bolster their own balance sheets. As a result they have grown more selective. Asset-backed loans are the norm, as cash flow loans have become tougher to obtain. Generally, debt multiples are expected to come down to 4.5 or 5 times Ebitda -- or lower, industry executives say.

Even the highest-quality assets are not immune. Spreads on credit have widened dramatically, industry sources say. With the secondary market for leveraged loans now hitting all-time lows, the riskier loans are being avoided, but good-quality issuances are by no means a slam dunk either. "The market is punishing even quality credits," Epley says.

Hard-pressed to price risk in the current tumult, banks are looking to protect themselves, adds Epley. To get a deal done today, sponsors would need to provide underwriters with virtually unlimited pricing flexibility, known as "full flex" in the industry argot.

At least up until a few weeks ago, the markets, while glacial, seemed somewhat functional. Large buyouts of $1 billion or more were still being done, with anything more than $3 billion being exceptional. In June, for instance, ConAgra Foods Inc. completed the sale of its commodity trading unit to Ospraie Special Opportunities Fund, General Atlantic LLC and Soros Fund Management LLC for $2.8 billion. The deal was initially financed entirely with equity, says a source close to the transaction, but the target later obtained a $1.5 billion asset-backed loan facility for working capital.

Deals now require more equity and improved lender terms. In July, the sale of the Weather Channel, valued at roughly $3.5 billion, to a consortium of NBC Universal Inc., Blackstone Group LP and Bain Capital LLC was made possible by the certainty of the financing package put together by the buyers. Slightly more than half of the price tag was equity, split nearly equally among the three sponsors.

The $4.1 billion LBO of Bristol-Myers Squibb Co.'s ConvaTec wound therapeutics and ostomy unit by Nordic Capital and Avista Capital Partners, among the largest deals announced this year, offered similar features. The size of the investors' equity check, at more than 50% of the deal's value, was crucial, as were terms offering Bristol-Myers greater deal certainty, such as the right to sue the buyers to fulfill their agreement to provide equity financing. J.P. Morgan Chase & Co. underwrote 100% of the $2.4 billion debt package at a time when many banks couldn't underwrite more than 25% to 50% of a deal.

Even the long-delayed $23 billion buyout of Clear Channel Communications Inc. was completed, after a bruising legal battle. The deal went through with revised terms, but the underwriters -- including Deutsche Bank, Credit Suisse Group and Royal Bank of Scotland Group plc -- have struggled to unload the debt without steep discounts.

The energy and commodities sectors appear to be among the few exceptions. Oil and gas, infrastructure and alternative energy, in particular, are very attractive to sponsors, because these offer high-growth opportunities and less leverage is needed to generate returns, notes Robert Kennedy, a partner at law firm Jones Day.

In August, Eagle Rock Energy Partners LP, a master limited partnership backed by private equity sponsor Natural Gas Partners, said it increased the size of its senior secured credit facility to $980 million after the interest rate on the loan was lowered late last year. The revolver, led by Wachovia Capital Markets LLC and Banc of America Securities LLC, is priced at LIBOR plus 175 basis points, according to Eagle Rock CEO Joseph Mills. "You couldn't get that deal today -- you couldn't pray for that deal," he says.

Unlike most MLPs, which tend to be pure plays, Houston-based Eagle Rock runs three business lines: oil and gas exploration and production, natural-gas gathering and minerals. But like most MLPs, it has non-investment-grade debt. Eventually, after the market settles, the company plans on seeking permanent debt financing, says Mills, but he adds that the high-yield market is too expensive at the moment.

Even so, not everything is rosy, even in the booming energy sector. "Energy deals in the private equity space are not immune from the credit crunch," says Bruce Herzog, a partner at Willkie Farr & Gallagher LLP. "We've seen significant financing issues with some of their portfolio companies."

The challenge for everyone is finding any senior debt financing at all, says Palden Namgyal, founder and senior managing director of Atlas Advisers LLC. "No one is willing to take underwriting risk," he says.

Financing for certain deals such as the $1.6 billion take-private by Blackstone Group of healthcare services provider Apria Healthcare Group Inc., announced in June, is still pending. And lest we forget, there's still the mammoth C$52.3 billion ($51.3 billion) purchase of Canadian telecom giant BCE Inc. by Madison Dearborn Partners LLC, Merrill Lynch Global Private Equity, Ontario Teachers' Pension Plan and Providence Equity Partners Inc., which after more than a year has yet to close.

Amid the latest financial crisis, one attorney advising on a still-pending LBO deal has grown anxious that the financing will crumble: "I'm nervous the loan terms could change dramatically."

There are parallels in Europe. Overall activity in the U.K. buyout market declined significantly in the first half of the year, notwithstanding a few large take-private deals that went through and a relatively strong midmarket. Private equity deals that are still pending are understandably less certain of their outcome.

Uncertainty has spread to everyone across the board, says Neil MacDougall, managing partner of London private equity firm Silverfleet Capital. "My read of the situation is nobody knows, no matter who they are. We won't know for two to three weeks," he says. "We've been tracking a few assets that should have been in the market and are not. My feeling is, we need a deal to be done before people get the feeling there is life after death after all."

The reality is that all deals have become more complicated since the start of the summer, sources say. After the record £45.9 billion ($85 billion) in 2007 (and £24.5 billion in the first half), the U.K. buyout market totaled £11.0 billion in the first half of 2008, according to Nottingham University's Centre for Management Buy-out Research. The number of deals also will likely reflect the shortfall, with 255 deals in the first half of this year, versus 669 for the whole of last year (and 351 in the first half of 2007).

Within days of Lehman's collapse, a consortium led by Providence Equity Partners withdrew a £3.13 billion proposal for business-to-business publisher Informa plc, abandoning one of Europe's biggest LBO transactions since the credit crunch began last summer. Although there was no guarantee that the deal would have been done at that price even before the market meltdown, the Informa board said that it recognized that the current turmoil in the credit markets would have been a challenge.

Julian Hirst, managing partner of advisory boutique Tri-Artisan Partners Europe LLP, says it's hard to do a deal of any size at the moment, let alone one of Informa's magnitude. Banks are unwilling to take holding positions of more than £25 million apiece, he notes. Some are having to club together even for deals of £100 million. For a £1 billion transaction, several banks would be required, and few would be willing to underwrite it, he adds.

"There's no such thing as an underwriting anymore," Hirst says. "Once you've got more than, say, five banks together, it becomes unmanageable to keep them all in line. They all want slightly different things. It's like herding sheep -- impractical, really."

The middle market, while still open for business, has its share of woes, too. "It's absolutely more expensive and more difficult to get financing," says Scott Adelson, co-head of investment banking at Houlihan, Lokey, Howard & Zukin Inc. "Terms have improved significantly for lenders."

Senior debt typically would be in the range of LIBOR plus 525 basis points, while mezzanine debt has increased by 100 basis points, with contractual returns around 15%. Lenders are requiring either warrants or an equity co-investment to get returns in the high teens, and many are insisting on full-flex terms.

Moreover, banks simply don't want sizable cash flow loans on their books, preferring the safety of collateral to securitize the loan. "The trend toward [asset-backed lending] is unavoidable," says Ron Kahn, managing director at Lincoln International LLC, a middle-market investment bank based in Chicago. "ABL money is out there," says Kahn. "Cash flow money is not."

As far as pricing goes, ABLs are, if not cheaper, then at least comparable to cash flow loans. By Kahn's estimates, the senior piece of an ABL would have a term of LIBOR plus 250 basis points. Blended with a second-lien piece, about LIBOR plus 1,000 basis points, it comes out to about 10%, which is roughly the same as a cash flow loan. If midmarket borrowers have "decent" assets, "that's the way they're going," he says.

"There is definitely more ABL as banks are getting more conservative," says John Brignola, executive vice president at LBC Credit Partners Inc., which provides junior debt to middle-market companies. "If you need a larger cash flow loan, that's a problem right now."

Not to say that cash flow lending isn't available. Houlihan Lokey's Adelson says that companies touting $20 million in Ebitda can get loans, but at more conservative multiples.

To some extent, this has led to a bifurcation between asset-backed and cash flow lenders, where cash flow lending has become the purview of nonbank providers, says Gregg Smith, senior managing director and group head of CIT Investment Banking Services. Bank of America Corp., PNC Bank NA, National City Corp. and others are all doing asset-backed loans almost exclusively, according to sources. On the other hand, specialty finance firms, such as CIT Group Inc., General Electric Capital Corp. and Madison Capital Funding LLC, among others, appear to have the cash flow market to themselves.

Meanwhile, everyone agrees that syndicated loans are a thing of the past. "Trying to syndicate anything is a nightmare," says Kahn. "I don't think there's any syndication available for anybody."

There is no single solution to the problem of financing. Buyers have fashioned creative structures and tapped new sources of financing. "I'm sure people will turn anywhere if they can't get the money," says Robert Morris, managing partner of private equity firm Olympus Partners.

Buyers are increasingly adding considerations to sellers, such as one- to two-year earnout provisions, to enhance their bids. In a recently closed middle market transaction, says Cyrus Lam, a director of KPMG Corporate Finance LLC, a seller took a two-year earnout consideration that boosted the absolute value by 40%.

In capital structures, mezzanine funds have raised their profiles considerably. In the U.K., borrowers are increasingly looking at mezzanine financing for transactions that previously would have been done without, says Peter Brooks of Lloyds TSB Development Capital, the private equity arm of U.K.-based Lloyds TSB Group plc.

Certain large pension funds, such as AlpInvest Partners NV of the Netherlands and Canada Pension Plan, have become active mezzanine lenders to buyouts through their relationships with private equity investors. This doesn't necessarily constitute a trend, however, because few pension funds have the infrastructure and resources to make direct investments.

Hedge funds have also stepped up to some extent, but this is largely viewed as opportunistic investing. Some sponsors find it "unwieldy dealing with hedge funds" because it involves bringing in as many as six or eight of them to take several small pieces of debt, says Deutsche Bank's Epley.

Moreover, suspicions persist among sponsors that, as holders of large portions of syndicated debt, hedge funds could force a company into restructuring, sources say, whereas traditional lenders might be more inclined to give a company breathing room.

Midmarket investor Arsenal Capital Partners Inc., for one, has turned to hedge funds for financing, including Silver Point Capital LP and Dymas Capital Management Co. LLC. The firm liked the fact that these funds "have a less formulaic approach" to investing and the firms were comfortable with the complexity of Arsenal's transactions, says Terrence Mullen, managing director at Arsenal.

Is there light at the end of the tunnel? No one can tell at this point. Investors may put on a brave face while waiting out the financial crisis. Still, there are those who believe the worst may be over. "This has all the characteristics of a market bottom," says David Harris, CIO of wealth management firm Rockefeller & Co. For investors, he adds, that creates the potential for attractive returns.

As Namgyal of Atlas Advisers sees it, 2009 could shape up to be "a very good vintage year" for sponsors as valuations continue to correct and leverage gradually becomes more available.

-- Vyvyan Tenorio contributed to this story.

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