Will CFOs and their executive management teams forge sensible deals if buyout firms begin to swamp them with offers?
An outbreak of heated bidding isn't far-fetched. It's been well documented that private-equity firms hold heaps of capital ("dry powder") to invest — more than $500 billion in March, according to London-based research firm Preqin. They began to deploy it in the second quarter. Globally, the volume of private-equity-backed buyout deals tripled year-over-year, to $43.3 billion, according to Preqin. Almost half the deals were leveraged. Exits by PE firms numbered 140 and were up 57% in total dollar size, providing much-needed liquidity.
"Private-equity firms are dying for acquisition candidates," says Ed Hackert, a partner in the transaction services group at Marcum LLP, a large accounting firm. "I've met with 25 to 30 PE firms over the last six months that we've never done business with," he says. "They want to leverage our client base to identify potential deals."
"Debt is more available, although it is still not a walk in the park," points out Steven Kaplan, professor of entrepreneurship and finance at the University of Chicago's Booth School of Business. "PE money is burning up fees — they need to put it to work."
At the same time, the supply of quality assets remains somewhat scarce, say experts. The bar for a quality asset is higher today than three years ago: acquirers want sustainable revenue streams, proper internal and operational controls, cost-containment strategies, strong earnings patterns, and solid management. "When a good-quality asset comes to market, it's a real feeding frenzy," says Stephen McGee, a practice leader in M&A at Grant Thornton. Adds Justin Wender, former president of Castle Harlan, a private-equity firm: "Pristine companies are very salable."
Growth Versus Synergy
From the seller's point of view, it's up to the CFO to discern whether it's the right time to sell, and if a suitable buyer is out there. American Renal Holdings, which owns and operates dialysis clinics, found the right buyer last May. The seller, Pamlico Capital (formerly Wachovia Capital Partners), had grown the company from 25 clinics in 2004 to 83 clinics currently, quintupling its revenue. Private-equity firm Centerbridge Partners approached Pamlico about acquiring American Renal, says Neal Morrison, a Pamlico partner. "It had significant upside, and was hard to let go," he says of American Renal.
Yet a private-equity sale made sense, especially with IPOs closed to the middle market and considering the market dynamics in dialysis clinics, says Morrison. Two companies controlled 65% of the market for dialysis clinics, but they were using a different business model in which they employ their physicians. American Renal's disruptive model is to set up joint ventures with physicians, so selling to one of the large operators was out, since the company's growth was coming at their expense. "They could pay us for synergies, but they would have struggled to pay us for growth," Morrison says. "And management wanted to continue to build the business."
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.
Motivated Buyers
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.
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