Good deals will get done in middle-market M&A

By Dan Reid, National Managing Principal, Transaction Advisory Services

The most recent active mergers and acquisition period has caught most by surprise. Many believe that it is likely to lead to reduced activity in private equity M&A as a whole. While we expect to see some changes in the upper and mega-market private equity deals, we do not foresee a complete fall off in activity and we believe middle-market private equity activity will remain robust with certain changes expected. Here is a brief glimpse of what we see unfolding in the next few months:

1. Many of the larger private equity firms that rely on public debt markets or more esoteric financings, specifically high yield debt and other debt with covenant-lite or no-covenant features, will be most heavily impacted by the credit crunch. We would expect to see buyers going back to the table to figure out different financing structures or terms for their transactions. Recent examples of this include TXU or Home Depot. Specifically the Home Depot deal reportedly has been restructured to include the seller retaining more of the company, different financing sources and other new terms. While we believe most of the deals currently on the table will get done, you should expect to see some “redrawing”
   of the terms to do so. Going forward, the larger deals will be structured so as to take into account the
   changed credit environment. We might see some decrease in multiples as sponsors are less able to rely on debt to reach the “edge of the envelope” in terms of putting together a winning bid.
2. The good news is that most middle-market deals rely more on traditional capital structures involving senior debt, more traditional mezzanine debt and sponsor equity. Since these types of debt are less impacted by the current credit crisis, middle-market deals will be less adversely impacted by the recent developments in the credit markets.
3. Traditional banks and lending sources still want to finance good deals. At the end of the day, this is the business they are in, and even in a tight lending market, they need to put their money to work. Therefore, look for traditional middle-market lending sources to continue to finance quality deals.
4. At the same time, buyers will focus on making sure their lending sources are on board early and kept in the loop so as to avoid last-minute surprises. The need to work closely with lenders increases as credit markets tighten. Banks will be more interested in the results of due diligence and will be more involved throughout the process. We have already seen lenders much more involved early on in the process on recent transactions.
5. Middle-market deals tend to involve private companies; therefore, inherently these deals have a greater degree of flexibility when it comes to finding a way to structure the transactions. Look for increased use of seller notes, earnouts and seller rollover equity as tools to bridge the gap between seller expectations and buyers’ ability to finance the purchase price.
6. Private equity firms continue to raise capital from investors and that, coupled with the existing overhang, means that significant volumes of capital are available and need to be invested in M&A.
7. This recent period with high M&A activity levels is different from what we saw during the period of the late 1990s and early 2000s in terms of the quality of the underlying portfolio companies. Following that prior active period, many private equity firms found that they needed to devote significant amounts of time working on underperforming portfolio companies. However, having learned from this, most private equity companies seem to have kept their eyes on the ball as it relates to their portfolio companies and seem to have emerged from this active M&A period with a strong portfolio of companies. As a result, these private equity firms will be able to stay focused on an investment strategy without turning their efforts around or “fixing” existing portfolio companies.
8. Cross-border deals will continue to drive deal volume. United States private equity firms have an increasing interest in global outbound deals. Likewise, inbound money from India, China, Europe and elsewhere will add to the already competitive transaction environment. 
9. Strategic buyers are becoming more active in the M&A arena. The emergence of strategic buyers, coupled with previously mentioned increased cross-border activity, will keep M&A activity levels high.
10. Private equity firms will not be able to turn to refinancings and recapitalizations as a means to achieve liquidity for their portfolio investments. Anytime we enter tighter credit markets, these alternatives become more difficult to structure. Without recapitalizations and in a less than frenzied IPO market, sales of portfolio companies may be the best way to achieve liquidity for a private equity firm. Thus companies that in the recent looser credit environment might have been recapitalized and held by a private equity firm, now might be put on the auction block. Perhaps we might experience an increase in the number of sponsor-to sponsor deals.
    As in all markets, even in a down market, good deals will get done. Given the recent pace of deal flow, any of these factors that continue to support M&A activity will go a long way to maintaining robust middle-market activity, even if the pace slows down for other reasons – such as more selectivity in investing and tighter scrutiny by financing sources. All of this should mean that while we might not maintain the frenzied pace of the last couple of years, we do not expect to see any significant slowdown in middle-market M&A.

Enjoy the other articles featured in this month's Private Equity Strategist:

• Merger and acquisition trends
• Cross-border mergers to play major role