Centerbridge/American Renal funded almost half of the $430 million deal with high-yield bonds. That was a little higher than the typical debt financing on buyouts this year, which has averaged 37% of total funding. “Sponsors are comfortable with more-conservative capital structures,” says Morrison. “It implies a bit less risk.” In addition, “they’ll be able to refinance businesses and recap them if debt markets improve.”
When private-equity firms inject more equity into deals, they figure in improvements in operations (resulting in better cash flows) and add-on acquisitions in which they can get more leverage. “They tend not to assume they will get a higher exit multiple,” Professor Kaplan says.
What will drive deals going forward? The probable expiration of the Bush Administration’s capital-gains tax break at the end of the year will motivate many business owners to exit. It will also stimulate activity by PE firms. “The whole tax regime is negatively predisposed to sponsors, so this is the last favorable tax year as they see it — they’re trying to get under that window,” says Howard Lanser, director of M&A at Robert W. Baird.
Generational trends are also at work. To private-business owners contemplating retirement, selling a controlling interest to a private-equity firm can keep them in the game, diversify their interests, and reduce risk. “Say I’ve built a business that could double in five years, but I know growth has risks to it,” says Kenneth H. Marks, a managing partner at advisory firm High Rock Partners. “I don’t want to find myself at 55 having blown up my company.”
But no matter how much it may appear that private-equity outfits want to buy, not every company is a desirable target. Although the middle market is especially active, firms need at least $10 million in earnings before interest, taxes, depreciation, and amortization to sell to a private-equity firm, says Marks. At that level, cash-flow financing is available to help the PE firm get to the desired leverage level, he explains.
Some firms would also be wise to wait. Without robust information systems, a well-constructed management team, and properly documented business relationships, for example, a firm has no ability to grow, says Marks. “The difference in valuation if you’re just talking about growth versus actually doing it is dramatically different,” he says. “It’s worth waiting a year.”
Waiting can also help to firm up valuations. Right now, says Grant Thornton’s McGee, “buyers can still use the bad economy and high levels of uncertainty as excuses to keep valuations down.”
Vincent Ryan is senior editor for capital markets at CFO.
The Strategic Option
Not every company is selling to
private-equity firms. Strategic buyers, with bushels of cash, are becoming more acquisitive. Total second-quarter M&A activity was $546.5 billion, although it grew slower than the private-equity portion at 5.4%.
And a corporate suitor can simply be a better fit. As an example, private-equity firm Castle Harlan agreed to sell portfolio firm Ames True Temper, a $443 million maker of lawn and garden tools, to holding company Griffon Corp. in July. Although Ames struggled through 2008 and saw sales fall 10% in fiscal 2009, the deal still had a purchase-price multiple of 8.8 times earnings before interest, taxes, depreciation, and amortization, a price about average compared with other deals done early in the third quarter (see chart, above). In addition, “Ames is now part of a larger entity with a broader relationship to the customer base,” says Justin Wender, former president of Castle Harlan. “They have low leverage and access to public capital to do transactions.”
While Griffon financed the deal with a $500 million term loan from Goldman Sachs (and $75 million in cash), the buyer is expected to redeem $300 million in bonds that represent almost all of Ames’s outstanding debt. “We don’t sell to someone who highly leverages the company,” says Wender. “A too highly leveraged deal also means you risk the inability to close.” — V.R.