Middle-market Finance Forecast: 2006

From two investment bankers, prognostications for the coming year.

For distressed middle-market companies, 2006 may bring tidings of more financing alternatives than those businesses have enjoyed in recent years past. For all the companies in that bracket — between $250 million and $1 billion of annual revenue — a number of other trends suggest a healthy dose of realism, although not pessimism.

As an example of a comeback, consider Second Chance Body Armor Inc., which in October 2004 filed for Chapter 11 bankruptcy protection. Second Chance had been targeted by lawsuits alleging that the company had sold defective bullet-resistant vests to police officers; when it filed for bankruptcy, the company had negative earnings and a debt-to-asset ratio of nearly 1:1 ($42.16 million of debt to $43.2 million of assets).

The following summer it was on the auction block with an asking price of $12 million. “Its liquidation value was half that,” says Rick Chance, a managing director at Trenwith Securities LLC, the investment bank that worked on the deal. But on July 27, the beleaguered company was snatched up by Armor Holdings Inc., a $1.4 billion maker and distributor of security products and vehicle armor systems. The price for the aptly named Second Chance was bid up to a whopping $45 million, which paid off the senior lender completely and provided $26 million to unsecured creditors, says the Trenwith banker.

So much capital is available, he observes, that it is not unusual for the sale price of a distressed middle-market company to jump 50 percent or more above its liquidity valuation. “Even when the company has been beaten up and there doesn’t seem to be much hope of raising debt, we continue to see [healthy] merger-and-acquisition activity,” says Chance.

His colleague Doug Ivan, another managing director at Trenwith, believes that in the coming year, troubled middle-market companies such as Second Chance will have more access to debt-based recapitalization, hedge-fund borrowing, and PIPE (private investment in public equity) investments than in the recent past.

Chance and Ivan have identified several other trends for 2006 that should prove useful to finance executives at middle-market companies and at companies that do business with them. Their prognostications:

• The slow, steady rise in interest rates may boomerang on some private-equity investors. Like their commercial-bank counterparts, these investors were very generous with capital when interest rates were low, so many of their portfolio companies are highly leveraged and in danger of financial distress. Commercial banks are expected to pull back from some troubled companies; indeed, banks are already staffing up their workout departments in anticipation of a rise in loan-covenant defaults.

• The Bankruptcy Bill of 2005 did not increase the number of Chapter 11 and Chapter 7 filings as much as had been forecast, but more regulation, rising interest rates, and the residual effects of hurricanes Katrina and Rita will take their toll in 2006. Many companies with suspect fundamentals borrowed from hedge funds when those unregulated entities jumped into the fixed-income market. Some of these high-risk borrowers — which obtained hedge-fund capital at a lower cost than they could from traditional secured loans, mezzanine financing, or straight equity — will likely collapse under the weight of too much debt in a higher-interest-rate environment. The exact timing of a boost in bankruptcies is hard to predict, but the writing is on the wall, say Chance and Ivan.

• Reverse mergers will supplant initial public offerings, both for U.S.-based and international middle-market companies. A reverse merger, in which a private company in need of capital sells itself to a publicly traded “shell,” is often attractive for smaller companies that find IPO costs prohibitive or due diligence too burdensome. (Shades of the 1990s: In today’s IPO market, only large companies and technology plays attract much attention.) Chance and Ivan expect to see reverse mergers in manufacturing and other old-line sectors, such as printing.

• Globalization will hasten the consolidation of investment banks, especially those that serve the middle market, as they struggle to play catch-up with bigger firms that have international expertise. Trenwith Securities reports that 60 percent of its business in 2005 included an overseas component as more of its client companies began outsourcing to China or India.

Commercial banks will also continue to consolidate. The smaller players are facing additional costs due to Sarbanes-Oxley, a generally heightened awareness of regulatory oversight, and rising interest rates; as a result, the liberal premiums buyers once offered for these banks will shrink.

M&A activity in the investment and commercial sectors is good news for clients who require more scope. However, finance executives will have to troll for new banking relationships that offer lending criteria and capabilities that fit their businesses, and their budget.

• The quest for higher yields will lead many investors to ignore financial, operational, and economic risks that should increase the price of debt, say Chance and Ivan. As a result, they add, marginal companies will continue to find their way into mispriced deals — and many of those companies will falter.

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