Private equity groups aren’t the players they were before the credit crunch

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By Aaron Kremer

When investment bankers were looking for buyers for Goochland County’s Paladin Tools in late 2007 some private equity groups showed interest. But the normally big-spending PE firms offered less for the company than corporate bidders who hoped to fold the business into their existing operations.

Matrix Capital Markets Group, a Richmond-based investment bank handling the deal, eventually sold Paladin for an undisclosed amount to a Pennsylvania-based division of Textron Inc. Paladin makes a tool for working with wires and cables that nicely complements the division’s existing products.  Matrix was confident Textron could come up with financing, which wasn’t a sure thing with the private equity firms in the bidding.

That situation is a departure from the recent years, when private equity (pools of capital gathered from wealthy investors) was a big player in mergers and acquisitions. If the deal had occurred last year, private equity firms likely would have been neck-and-neck with corporate buyers in competing for Paladin. “At the end of the day, it’s tough to get [private equity] deals funded. The credit markets have declined in the last 18 months,” says C. Bryan Johnson, a vice president at Matrix.

Around Virginia, deals are still getting done, but in some cases prices are falling. Blame the credit crunch resulting from the subprime mortgage fiasco. Banks, buffeted by defaults on mortgages and the falling value of mortgage-backed securities, are more hesitant to lend to PE firms, which rely heavily on borrowed money to fund their acquisitions.

The crisis has caused turmoil on Wall Street, prompting the government to rescue insurer AIG and mortgage finance giants Fannie Mae and Freddie Mac. Banks took over investment firms Bear Stearns and Merrill Lynch, while a third firm, Lehman Brothers, filed for bankruptcy.

Last year, the 25th biggest deal in Virginia was valued at $120 million. Through July of this year that number is $15.8 million, according to lists furnished by Richmond-based investment bank Harris Williams & Co. using data from Thomson One Banker. (The lists include transactions in which the acquisition target was a company with corporate or administrative offices in Virginia.)

So far, the most expensive deal of 2008 in Virginia has been Hewlett Packard’s acquisition of Electronic Data Systems Corp. for $17 billion. (EDS, the world’s second-biggest computer-services provider, is based in Plano, Texas, but has an administrative office in Herndon.) That deal closed in August. By comparison, the largest Virginia-related deal last year involved the acquisition of Mills Corp. (the Maryland based owner of Potomac Mills) by Simon Property Group and Farollon Capital Management LLC for $9.2 billion.

Second on the 2008 list is the proposed acquisition of Abingdon-based coal producer Alpha Natural Resources Inc. by Ohio-based Cleveland-Cliffs Inc. The transaction was worth $9.7 billion when announced in July. Harbinger Capital Partners, a hedge fund that owns 18 percent of Cleveland-Cliffs stock, opposes the deal. (The list of proposed deals announced through July does not include Richmond-based Altria Group’s $11.7 billion acquisition of UST Inc., which was announced in early September.)

Among the top five deals was the sale of one of Virginia’s Fortune 500 companies, Goochland County-based Performance Food Group. It merged with Denver-based Vistar Corp. in a deal worth $1.3 billion. The merged company now is owned by New York private equity firms The Blackstone Group and Wellspring Capital Management LLC.

While the pace of such big-dollar deals has slowed, investment bankers say the middle market — transactions of $25 million to $500 million — in Virginia is far less affected by the credit crunch. Smaller deals typically rely less on borrowed money.

At Harris Williams, a middle market specialist, deal volume is about the same as last year; about 60 deals since August 2007, says Hiter Harris, the company’s founder and president.  Companies are acquiring smaller firms in their industry and then folding those acquisitions into existing operations, he says. For some companies, it’s a cost-effective way to grow. “Corporate buyers, this is their time to shine.”  Harris says. “Their earnings are still good, and with clean balance sheets, they feel like they’re more competitive against the [private equity] groups.” He says that corporate buyers are typically active in 50 percent of the deals his firm handles. That figure has risen to 70 percent lately.

Deal volume at Reston-based Monticello Capital is down slightly from last year. Companies that are considering putting themselves up for sale are looking harder at term sheets that determine how much of a cut the investment bank receives, says Michael Pocalyko, the firm’s president. Pocalyko and other investment bankers don’t expect M&A volume to pick up in the next several quarters because private equity firms will continue to face pressure from capital markets and from their investors.

Private equity investors demand much higher rates of return than what typically can be obtained in the stock market. The way to achieve those returns is by using leverage. That’s typically in the form of senior debt (bank debt). Using debt, a PE firm has lots more money to work with in acquiring a company. If the firm later sells the company (an event that typically happens within five years), its profit is much greater than if firm had paid cash in the initial acquisition.

Top 25 Virginia deals proposed in 2008 (part 1)
Top 25 Virginia deals proposed in 2008 (part 2)
Top 25 Virginia deals proposed in 2008 (part 3)

The reduced access to credit is slowing the activity of private equity firms and making some investors nervous. “The risk aversion has bled over into pension funds and publicly managed investment funds,” Pocalyko says. “That carefulness didn’t exist a year ago.” 

With less access to borrowed money, private-equity firms are offering lower prices for some of the companies they aim to acquire. There are also fewer bidders, a situation that results in lower prices. However, some high-growth companies are still in great demand. “Yes, the valuations and multiples are coming down. But for really good, rock-solid
companies that are modestly growing, those companies are still getting great valuations,” says Jeff Moore, the president of Matrix Capital.

Multiples represent the ratio of a company’s selling price to its earnings before interest, taxes and amortization (EBITA). Multiplies vary based on industry, says Patrick Galleher, a principal at Boxwood Partners, a fast-expanding M&A shop in Richmond that also has a PE group called Boxwood Capital Partners. But across all deal types, ballpark figures have fallen from six to nine times EBITA to five to seven times, he says.

Investment bankers around Virginia say that down periods of the M&A cycle actually present opportunities to hire fresh blood. Harris Williams is getting hundreds of résumés and will add talent in the coming year. Boxwood Partners is also hiring. The company formed earlier this year with investment bankers from other firms around Richmond and now has seven employees. Galleher says he expects that number to reach 12 or 15 by the end of the year.

Boxwood’s M&A division completed its first deal in August — selling a metal manufacturer to a division of a private-equity-owned company. The target company was in Alabama. Boxwood now has two Virginia deals in the pipeline, Galleher says. “For the right deals in today’s marketplace, there is still a lot of interest.” 






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