The waiting game

US buyout firms are cash rich and pricing looks sweet, but unless the debt markets reopen, dealmaking will remain slow, writes David Snow in New York.

Buyout professionals in the US find themselves in a situation that can best be summed up by a line from the opening scene in Casablanca: they wait, and wait and wait?They wait for an end to the current moribund deal market and the beginning of a new cycle in which debt financing is available, sellers motivated, purchase-price multiples low and ?dry powder? stockpiled.

Today, only the latter two of these four conditions are in place, leaving buyout firms, in a sense, all funded up with no deals to do.

The desperate and the long-suffering
that purchase multiples were unrealistically high. Business owners, they said, demanded rich valuations based on inflated assumptions of earnings growth. Now that valuations have come down to earth with a thud, however, the deal stalemate has yet to be broken. Business owners have divided into two camps ? the desperate and the long-suffering. The business owners that fall into the desperate camp fear their companies may go bust unless they secure fresh investment capital. As such, they are more than willing to accept deflated valuations. But, alas, most buyout firms wouldn't touch these businesses with a barge pole.

The business owners in the long-suffering camp, on the other hand, are in no danger of going bankrupt and are content to sit and wait for purchase multiples to creep back up, despite the best efforts of acquisitive private equity funds to persuade them otherwise.

At the root of the inability of buyers and sellers to agree on price is the state of the US financial markets. Debt, particularly senior debt, is available in smaller quantities, and at lower multiples of earnings, than at any point in recent memory. Thanks to shattered faith in earnings forecasts, banks are as conservative as they ever have been about financing buyouts. Having been burned by skyrocketing default rates, partly the result of easy credit during the mid- to late-1990s, banks now approach lending with an intense degree of caution. Indeed, according to rating agency Moody's Investors Service, the default rate on corporate bonds reached 9 per cent in the third quarter ? the second worst on record ? and is expected to peak near 11 per cent in 2002.

Banks are also more conservative because of increased pressure from regulatory bodies, particularly the powerful Office of the Comptroller of the Currency, which digs through banks' portfolios and assigns ratings to loans. The OCC currently takes a dim view on risk, and this has influenced the amount of leverage banks are now willing to provide. In 1997, banks provided leveraged buyouts with an average debt-to-EBITDA ratio of 5, according to Standard & Poor's Portfolio Management Data. In the first half of 2001, banks provided debt for LBOs at an average of 3.7 times EBITDA.

As a result of this increased caution, private equity firms are faced with the prospect of contributing more equity into a deal's capital structure. Minus the leverage component, buyout firms must forecast down the returns they expect to make on leveraged buyouts. The steady rise of the equity component has been a standard feature of the buyout industry since 1987, the heyday of the LBO, when companies were bought with an average of just 7 per cent equity, according to Portfolio Management Data. Now the average equity contribution is roughly 39 per cent. In many cases, deals that make sense at, say, 35 per cent debt make no sense at 45 per cent, so the acquiring firms are forced to renegotiate with sellers on price. But according to buyout professionals, sellers have been less than accommodating on price, and this has led to a dearth in US buyout deals.

The unfolding recession in the US, as well as the events of September 11, guarantee that the task of getting deals done will remain challenging until well into next year. Some investment professionals say they are not planning on a return of the financial markets until 2003.

Thanks to shattered faith in earnings forecasts, banks are as conservative as they ever have been

High-yield may lead the return to normalcy
Still, US private equity firms are scanning the horizon and waiting for the day when, as one investment professional puts it, ?the sun and the moon and the stars are aligned again.? They are waiting for regulatory agencies to ease up on leverage structures. They are waiting for true visibility on earnings, as opposed to wild fluctuations and inaccurate management projections.

Many believe that the first sign of the return to ?normalcy? will come from the high-yield market, which tends to embrace risk earlier than the senior debt market and, to a certain extent, competes with it for business. Once providers of high-yield debt begin to show comfort on earnings, the reasoning goes, the banks are sure to follow.

In particular, some buyout professionals are waiting for an increase in the number of pricings of single-B high yield bonds ? an indication that bond buyers are willing to embrace a slightly riskier security than has been issued since September 11. Hope arrived in October in the form of a $200m, single-B bond pricing for Petco Animal Supplies, a Leonard Green & Partners portfolio company, and a number of additional similar offerings are in the works.

That US buyout firms are hungry for deals involving solid earnings and a reasonable debt component can be illustrated by the surge of buyout activity in an industry known more for its plodding sameness than for its explosive growth ? the yellow pages. European readers will recall the acquisition last May of British Telecom's directories business, Yell, by Apax Partners and US buyout giant Hicks, Muse, Tate & Furst, for a whopping £2.14bn. The deal involved approximately £1.45bnin debt, including £500m in high-yield financing.

In recent months, yellow pages buyouts have been pursued by other major US buyout firms, including Texas Pacific Group, Thomas H. Lee Co. and Kohlberg Kravis Roberts. Yellow pages companies, it turns out, have remarkably steady earnings, thanks to their diversified customer base and absolute necessity as a marketing channel for local businesses. In an economy where once powerful companies are on the verge of bankruptcy, buyout firms, with their willing banking partners, are clamoring for publishers of directories as a relatively risk-free way to put capital to work.

There is a clear message here: if you want a sneak peek at what the US buyout market will look like once the haze lifts from earnings outlooks and lenders return to the business of lending, imagine the current fever for yellow pages let loose on the entire old economy.

David Snow is the editor in chief of, a New York-based Web site providing news and information on the private equity industry.