Hands-off Investing: Greater difficulty in executing deals, lethargic credit market may drive private equity to non-control investments

By Jonathan Marino

April 1, 2008– Mergers & Acquisitions

Cleveland, OH – Credit markets have spent months in the toilet, cramping efforts from PE shops to source and close deals. But the turmoil has also taken its toll elsewhere – on companies themselves, who now struggle to find the long-term, non-control financing necessary to keep business humming. It didn’t take long for both sides to find a compromise.

“There are not a lot of other sources of long-term equity capital for established mid-market companies,” says Tim Kelleher, managing director for Pacific Corporate Group Capital Partners, a private equity firm controlling more than $1 billion that is earmarked for non-control investments.

“In the last 18 to 24 months, there has been greater interest from companies” willing to consider non-control investments, he adds, noting that in prior years many of them would have simply secured more debt. Now, he insists, “More companies are receptive to meeting us.”

For PE firms flush with cash, it’s understandable that they’d prefer to pursue control deals. However, given the alternative of not putting money to work, especially considering how much capital has been plowed into the asset class, many will gladly yield control in certain situations.

“Non-control investments ought to increase in volume, given the unrelenting investment pressure the private equity industry is under,” says John Kaufmann, a partner with K&L Gates, a law firm specializing in financing and M&A. “Private equity funds raised $500 billion of new money last year, alone.”

To be sure, many in the mid-market have pursued growth financing investments in the past – even during strong markets. In fact, last year, when the market was at its strongest, PE firms notched 146 separate minority-stake deals.

At the same time, many buyers, when times are good, won’t consider such alternatives because the loss of control can handcuff investors if things go awry. In a control situation, for instance, investors can replace management teams or take other, more drastic measures if the situation calls for it. In growth financings, the investors are merely along for the ride.

But in non-control deals, PE firms aren’t necessarily attempting to come in as an agent of change. Rather, they’re typically hoping to capitalize on the rapid expansion of a company’s business – expansion that requires money as opposed third-party know-how to occur. When Sorenson Capital invested in Michael’s Finer Meats and Seafoods, Luke Sorenson, in a statement, talked about the “accelerated growth” that appealed to the investors. In control deals, it’s “consistent” growth that investors seek, in order to pay down the debt.

The same terminology used by Sorenson was found in Arsenal Capital Partners’ press release when the firm deposited a $30 million capital infusion into lender FirstAgain. Both deals occurred in February.

FirstAgain represents an example of the kind of business that might be drawn to a non-control investment. A consumer loan company, it targets the exact opposite type of borrower that would be classified as subprime. But credit-worthy or not, nearly all consumer loan companies are being viewed as toxic by lenders and investors, alike. A non-control investment, however, is the type of compromise that keeps both sides happy.

John Sinnenberg, CEO of Key Principal Partners, says that as mid-market companies see their valuations slide with the declining economy, they are still likely to be receptive to PE. What was once a valuation of seven times Ebitda has slid to as little as six, for example, which makes the prospect of a control sale less appealing. But to pursue growth and build market share, Sinnenberg notes that companies will be open to investments that allow them to maintain control and then possibly seek out a sale down the road when valuations perk up.

Sinnenberg adds that what begins as a non-control investment can sometimes bloom into a control play – although KPP does not enter a negotiation necessarily aiming for such a scenario. He also concedes that exits can be difficult in some circumstances, considering the investor can’t force a company to put itself on the block. “Some of them will never sell,” he describes, but in such an event, the company usually winds up reacquiring the investment.

And a sale back to the company is not necessarily a last resort. When FdG Associates exited its minority stake in dental benefits provider DentaQuest, the firm sold its holdings back to the company for $110 million. Five years earlier, in 2002, FdG had paid $12 million for the same minority interest.

Sinnenberg predicts that in the coming months, it is likely more PE firms will enter the non-control space, should the credit market continue its stagnation or slide even further. “Once it crystallizes for people,” he says, referring to the debt market’s prospects, “we’ll start to see an influx of capital.”

But Kelleher warns that PE firms not used to investing with a more passive approach should be careful. “It’s a different philosophy,” he says, noting that patience and flexibility are key attributes investors need.

At the same time, it’s the ability to compromise that gets these deals done in the first place.

© 2008 Mergers and Acquisitions Journal and SourceMedia, Inc. All Rights Reserved.

About Key Principal Partners

Key Principal Partners (KPP) is a $1 billion private investment firm that provides expansion capital to profitable middle-market companies with at least $30 million in revenue. The firm has the flexibility to provide any combination of subordinated debt, preferred equity and/or common equity in either non-control (minority ownership) or control (majority ownership) positions. KPP can invest between $10 million and $40 million to facilitate the growth, acquisition, refinancing, deleveraging or liquidity needs of private company owners and their management teams. Affiliated with KeyCorp, KPP is headquartered in Cleveland, and has additional offices in Greenwich, and San Francisco.

About KeyCorp

Cleveland–based KeyCorp is one of the nation’s largest bank–based financial services companies, with assets of approximately $97 billion. Key companies provide investment management, retail and commercial banking, consumer finance, and investment banking products and services to individuals and companies throughout the United States and, for certain businesses, internationally. For more information, visit www.Key.com.