By Michael Baron
If 2007 was the peak, and 2008 the reckoning, 2009 could very well shape up as the retrenchment.
With leverage scarce and deal flow sputtering, buyout pros are preparing for a year of tending to portfolio companies, sifting through distressed opportunities, and watching the headlines for signs of stabilization in the economy. “The industry is at a standstill,” said Greg Feldman, a managing partner and co-founder of New York-based buyout shop Wellspring Capital Management. “The big buyout firms have nowhere to go. Middle-market players should be able to pick their spots (in 2009), but it’s going to be a tough year for most people.”
In relative terms, compared to the heavy losses in the public markets and the historic re-shaping of the banking industry, private equity was insulated from the devastating fallout of the credit crisis by its longer investment horizon. After all, the firms themselves remain intact. The number of deals fell less than 20 percent and fundraising for U.S. buyout and mezzanine shops, while slowing from 2007, remained robust, higher than the totals for 2005 and 2006.
But that’s not to say the industry hasn’t been deeply affected. Just in the waning months of 2008, the industry saw a rash of layoffs at the top firms; the death of the two remaining mega-deals (BCE Inc. and Huntsman Corp.); one scuttled IPO after another (including the plans of LBO pioneer Kohlberg Kravis Roberts & Co.); declining levels of commitments from re-upping limited partners hamstrung by the denominator effect; substantial comedowns in progressive fund sizes (The Blackstone Group); and even one firm (Permira) taking the unusual step of letting LPs pull back from their commitment levels.
All of these developments were prompted by the worsening economic conditions, and that remains the biggest concern heading into 2009. After all, leverage is the industry’s lifeblood, and grim data points like rising unemployment and weak consumer spending don’t inspire the confidence necessary for lenders to shoulder risk. Expect equity contributions to continue to rise, along with the number of covenants required by lenders.
“For the use of leverage to come back, you need the banking system to stabilize, and for the banking system to stabilize, you need the economy to show signs of improvement,” said Steven Kaplan, the Neubauer Family Professor of Entrepreneurship and Finance at the University of Chicago. “Buyout firms have supposedly invested in operational efficiency over the past few years. We’re about to find out if that’s the case.”
In other words, financial engineering won’t cut it in a recession. Buyout pros are going to have to deliver the operational improvements they promise if they want to see their portfolio companies survive, let alone achieve respectable returns. Increasing numbers of buyout-backed firms are struggling with debt-laden capital structures that rely on rising EBITDA assumptions. A prolonged recession could lead to a wave of defaults and even fiscally-sound companies will suffer in an extended downturn. Turnaround specialists won?t feel so special anymore. Many firms may decide the best use of their dry powder is on equity cures for their ailing investments.
“Private equity is going to have a lot of tough decisions to make in 2009,” said John Sinnenberg, a managing partner with Key Principal Partners, a buyout shop headquartered in Cleveland. “Firms are going to have to determine which companies to support and which to let go.”
Mike Guthrie, a managing director with Symphony Technology Group of Palo Alto, Calif., expects the majority of buyout shops to spend 2009 shoring up their portfolios, sitting on their dry powder and waiting for the lending stalemate to break. His firm, whose expertise is in software, is now paying as much attention to the balance sheets of its targets as it is to their growth prospects. “While we’re taking a conservative view of all of our transactions, we’re aggressively pursuing situations where our partners’ operating experience can help us create substantial returns.”
Of course, without any clarity on when the economy is going to stabilize, it’s impossible to know how bad things could get. “Economic conditions continue to deteriorate and we’re getting to a point now that’s outside the normal predictive range of activity,” said Key Principal’s Sinnenberg. “Understandably banks don’t want to make cash flow-based loans outside of their core customers,” he added, explaining that banks have existing relationships with such customers within their footprints and can benefit by cross-selling many services to them. This has a much greater appeal in the current environment than a one-off deal.
That hesitation, and the justifiable fear behind it, is what is jamming up the system and what could make for a long, rather dull 2009. There’s no leverage, so deal flow is down. Weak deal flow means little sponsor-to-sponsor activity, fewer and fewer exits. Without exits, LPs lack distributions. Disappearing distributions hurt overall LP liquidity, leading to questions about possible defaults on commitments, the explosion of interest in the secondary market, lower re-ups, fewer fliers on emerging managers. On and on it goes.
Even the pockets of private equity that are expected to do well in 2009 are ones whose success is predicated on the problems in other core areas. The boom in the secondary market is being driven in part by LPs scrambling for liquidity, willing to sell fund stakes at deep discounts. Favorable market conditions for mezzanine lenders are the result of the shakeout among senior lenders and the extreme risk aversion among that group’s survivors. Even the most optimistic comment you’ll hear, that old saw about phenomenal deals being made in down markets, is predicated upon a return of the debt markets.
So what kind of deals will get done in 2009? No surprise there: distressed is top of the list. “Most deals will be forced sellers,” said Wellspring Capital’s Feldman. “No one who can afford to hang on is going to sell into a recession.” Club deals and add-ons could also be popular, as the former allows risk to be doled out in more palatable amounts among multiple firms while the latter provides a way to enhance an existing property, although banks may sometimes be unwilling to finance an add-on without reworking the capital structure of the underlying portfolio company. Some buyout pros believe strategic buyers may play a part in loosening things up, providing exit possibilities, as the IPO market is expected to remain largely dormant in 2009.
Until leverage returns and deal flow picks up, however, buyout pros might do well to think in the following terms. “When you’re buying, you should model as if you were going to own it forever,” said Ken Hersh, a managing partner with Irving, Texas-based Natural Gas Partners, at a recent Buyouts conference.
That sentiment is a far cry from the rip-and-run mentality that fueled the LBO boom, and it goes a long way toward explaining why 2009 may feel like the longest year in a while for general partners.
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.
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.