An Appealing Opportunity
By Gianpiero (JP) Balestrieri, Managing Partner
Washington DC Office, Corporate Finance Associates
Middle market investment
banking activities felt the
effects of the financial
crisis. M & A deal volume for the
middle market fell 39 percent in
2008 compared to 2007 and has
fallen even further into 2009. The
harsh credit markets have left their
mark on the middle market. The
average deal value in Q1 2009 was
$64.1 million, down from $93.4
million in the fourth quarter of
2007. The decrease in average deal
size can be accredited to conservative
valuations due to the added
risk and limited debt funds available.
The incentive for an owner
or principals to sell their business
has sharply decreased and left many
waiting for a more optimal, but
indefinite exit timeline.
Traditional business models and
financial investments have lost
effectiveness, allowing a higher
demand for alternative strategies
and investments. Private equity
groups are tentative to invest
because of the risk coupled with
difficultly accessing debt to leverage
the scale of their investments.
An alternative investment like a
Management Buyout (MBO) presents
an appealing opportunity to
private equity. Why? First, the baby
boomer generation is reaching their
retirement age and ripe for an exit
strategy with a structure that creates
choices for owners. Second, investing
in the current management
team to take ownership allows for a
familiar and friendly transition, and
in turn a more reliable and sustainable
future for the company. Lastly,
the trends in buyout valuation, debt
capital, and equity capital are all
enablers of MBOs for owners who
want to control their destiny at the
times they wish to exit, as well as
the values at which they prefer to
monetize their business’ value.
Baby boomers make up 28 percent
of the US population and 77 percent
of the financial assets in the US
are controlled by the baby boomers.
Baby boomers in ownership do
not have to conform to company
retirement regulations and plans,
so they are free to retire when they
desire, most likely sooner rather
than later in this current environment.
However, retirement in the
current marketplace is more uncertain
than it has been in the past.
Asset management firms investing
in safe and reliable stock and bond
portfolios have historically managed
typical retirement funds. USA Today
reported in October 2008 that retirement
portfolios have lost $2 trillion
(20%) in value, and that workers are
beginning to withdraw funds from
retirement accounts in fear of more
losses.
An MBO provides a comfortable
alternative exit strategy because of
the secure financial gains heading
into retirement and the comfort and
familiarity of passing the company
reigns to the current management
team. Creating a greater level of
certainty is mutually valuable to
both private equity investors and
owners wishing to exit at the values
they desire for retirement. For all
owners, it is not only a question of
price when selling your business,
but also about structure of the terms
agreed, which are more optimum
in an MBO transaction, given the
familiarity with the risks and the upside
of the target company between
seller and management/owner.
Apart from the raw data illustrating
that a large group is looking for a retirement
strategy, certain indicators
also point to MBOs as an optimal
investment alternative compared to
typical buy/sell side investments,
retirement plans, and equity markets.
Private equity groups have
access to funds, but not at the
traditional volume or interest rate.
The limited credit available allows
more investment opportunities in
the lower middle market because the
transaction size is more realistic and
affordable. Management buyouts
in the lower middle market offer
a relatively low risk and feasible
investment opportunity based on
several factors.
- The marketplace is turbulent because of weak credit lines and
the mountain of bankruptcies
that have resulted, making a
large equity investment intimidating.
The management team
of a company should, assuming
competence, be the best
group to produce success after
the current owner has left. A
strong company, before the
MBO, with a talented management
team is a reliable option
for continued success.
- Second, deal financing is a
concern for any investment
group during a credit crisis.
Reputable and experienced
private equity groups still have
access to limited lines of credit.
Private Equity Groups in the
lower middle market have a
distinct advantage due to the
lesser amounts of funds required
to invest and run successfully.
- Mezzanine financing is thriving
in the middle market because
of the limited commercial funds available. Mezzanine financing is ideal
for MBOs because of the equity warrants and
the flexibility of terms and conditions.
A smart investor/management team must be
aware of possible weakness. During this
financial crisis, company weaknesses will be
exposed quickly, and a sound management
team, familiar with the company, can adapt
appropriately.
The strain on the debt market has prompted
private equity groups to inject the highest levels
of equity into their transactions. The percentage
of equity injected by private equity groups in
leveraged buyout deals with companies having
EBITDAs below 50MM increased to 38.9 percent
up from 30.9, 31.1, and 29.8 percent in 2007,
2006, and 2005, respectively. Reduced debt-to-equity ratios push private equity groups to more
dependable investments.
Businesses and investors must be committed to
weathering the crisis with new strategies. Companies
in the middle market still have desire for
progression and private equity groups are keen
for conservative but rewarding investments.
Management buyouts are attractive for their
security, potential long-term reward without the
added risk, and friendly ownership transition.
There are companies that are prospering during
the recession and could provide lucrative returns
to the forward thinking investors, while creating
optimal liquidity events for owners at preferred
monetized values and with clear and determinable
structures.
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