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M&A ROUNDTABLE Pockets of Opportunity

Financing is harder than ever to come by, the sour economy is dimming prospects for once-worthy target companies, and many prospective acquisition candidates are moving to the market sidelines rather than accepting prevailing bid prices. A bad mix for LEO sponsors! Yet, they continue to look for the special situations and structures that will put their investors’ money to work.

M&A: This has been a very slow time for M&A in general and corporate buyers are holding back. Does this create any opportunities for you to buy companies that might have been priorities for strategic buyers, and what private equity techniques, such as pricing or recaps, could you use for an edge in these situations?

TAYLOR: I think that there are opportunities in this current environment. One technique is to do a partial recapitalization, where we acquire 50% or less of a company, thereby leaving the entrepreneur with significant upside potential. The value proposition of a partial recap to an entrepreneur is a lot better today than it was in the late ’90s. Back then, strategic buyers were offering to pay eight to 10 times cash flow, and almost every time the entrepreneur would take the cash on the table and sell 100% of the business.

But because valuation multiples are lower today, we are finding that owners/entrepreneurs are more interested in the partial recap approach, which lets them sell 50% or less of their company, diversify their net worth, and continue to build and operate the business. In our view, the pendulum is swinging back, and that is beneficial to the private equity firms.

TENBROEK: Wind Point is primarily a middle-market buyout investor, managing about $600 million in our active funds. Our strategy is to back strong executives and find businesses to buy for them. The recap sometimes works for us, but usually in a case in which we can bring another manager into the equation. Often our formula works with spin-offs of businesses or underperforming businesses.

What we’ve found is that even in the tough times, if the business is off strategy or a team isn’t quite cutting it, the corporate owner is still willing to sell. The prices have come down, which creates an opportunity for us on the exit three or four years from now. Financing has come down, too, so relative to several years ago we are putting in more equity to get deals done.

From the sellers’ perspective, they are getting less for their businesses today. But, if they are still willing to sell, the market has created opportunities for us because we do not have to compete with strategic buyers, and prices are down. We are still having good success at getting deals completed.

SCHAYE: At Chestnut Hill, we are somewhat different because we are originators for quite a few private equity firms. In terms of the marketplace, the playing field has been leveled for everybody in terms of pricing, and for corporate and strategic buyers, their currency has been devalued as their stock prices are down. As a result, that has created an opportunity for private equity firms.

They can get more into the debt market than a strategic buyer and provide a lot of strength on that side. So executing the leveraged recap and allowing the business owner to stay in and get two bites of the apple is becoming more advantageous. We’ve seen more of that happening now as opposed to taking the money and running.

TSUSAKA: At Brera we are seeing the beginnings of more structured transactions. I would say that more than 50% of the prospects we are looking at are highly complex in structure. For example, we are working with a large strategic buyer who has a subsidiary that it currently does not want to invest capital in. At the same time, it is not looking to divest it. The subsidiary has the opportunity to make an industry-redefining acquisition but is not being provided the capital by its parent.. As a result, the company has sought us out as a capital partner.

We are talking about governance issues and potential exits that cover everything from the company having a call option on our equity stake to our being able to put our interest back to it. We also are looking at potentially selling the entire company to some third party at a later stage or selling our interest through an IPO.

JONES: Berkshire Partners is a middle-market buyout firm, and we just closed our sixth fund with over $1.5 billion. We look to invest in growth-oriented companies, with management staying intact. We are typically looking for strong managers to partner with.

My colleagues here have talked about the current environment, including a decrease in some of the competitive elements. Although financial buyers may be more competitive relative to what some strategic buyers are paying, multiples have come down across the board. A lot of people look at that as good news. But we are also seeing that the number of properties has dropped off and the quality of what is available is probably deteriorating.

We are also seeing some corporations that, having decided to get out of a business, have become more rational with respect to price expectations because of the environment right now. They are willing, for strategic reasons, to divest anyway. Making a deal in this environment can lead to more complex structuring at times. For example, the seller may want to keep a minority interest so it can have some insurance on the future upside.

M&A: What about the downturn in the IPO market? Are you getting opportunities from people -who basically are looking for some kind of liquidity that they hoped to get from an IPO?

SCHAYE: In the second quarter of 2000, there were 98 IPOs and in the second quarter of this year there were 26 IPOs. That’s an incredible drop-off. The exit strategy for the middle-market company used to be “I can do an IPO.” Well, unless your name is Martha Stewart or the Worldwide Wrestling Federation, that exit isn’t available anymore. So a lot of people have said, “If I can’t do an IPO, this is an opportunity for the private equity community.”

There is more money in private equity than ever before. The number that has been bantered around is about $454 billion. It is incredible. This year alone, I think about $154 billion in private equity was raised. So you have all of that demand for product from the private equity community, and IPOs have shut down. Those are the factors that tell you there is opportunity for private equity firms to do buyouts.

“One of the trends that we have seen is a concentration on organic growth as opposed to growth by acquisition.”

JONES: Paul’s point is that there is clearly a much tighter window, if there is a window at all, for companies to go public. Whether that shuts down an exit alternative or eliminates the ability for a company to raise capital, it does redirect some demand to private equity. Berkshire looks to both buyouts and growth capital investments, so there are different ways that can play out for us. In general, we are seeing more opportunities from companies that had considered going public, or that already are public, but can’t raise capital.

TAYLOR: Advent focuses on well-managed companies with good growth prospects. So the downturn in the IPO market, coupled with lower valuations, makes this environment quite attractive to us. Most fast-growing businesses need to raise capital, and when the IPO market is shut down, that clearly creates opportunities for private equity firms. In our experience, great management teams want to accelerate their growth even if they are in a down economic cycle. In fact, some of the best management teams we have backed have made savvy acquisitions, or launched aggressive growth initiatives, during down cycles.

For example, we see outsourced business services companies that are investing in systems, acquiring competitors, and needing working capital. Depending on the needs of the company, we can do a straight growth equity investment, a low leveraged recap, or a buyout. So an environment like this works out pretty well for us.

SCHAYE: There used to be what I would refer to as the IPO deal de jour. At this point in time there is no IPO deal de jour. If you look at the deals that have been done this year, no segment is dominating the IPO industry. Someone in the telecom industry used to look at IPOs and say, “That is my avenue of exit,” and the market would zero in on multiple offerings from that industry. There is no light at the end of that tunnel for any one industry that suggests that the IPO is a common exit. It is not out there anymore.

TENBROEK: On the investing side, especially for industries that were once in favor and are now out of favor, there are now opportunities. A number of companies had thought they would access the public markets and can’t now.

Telecom, for example, has become a bad word, with a number of struggling companies out there. But there are also some good gems that never went public or are already public but can’t raise additional growth capital. A number of them are now circling around the private equity community, often looking for a sizable piece of private equity.

We don’t chase hot IPO markets. When an industry gets hot for IPOs, the whole industry typically becomes overheated and too expensive for us to play in. Even with a strategic purchase, the prices go up and the entire industry becomes out of reach. In a number of formerly hot markets, valuations for all companies have become normalized, and this has created opportunities for us.

M&A: How important is organic growth to the companies that you acquire of consider? Do you really have any quantitative criteria about growth? In what particular measurements do you want growth to take place as far as creating value is concerned?

TSUSAKA: We are comfortable looking at both slow-growth companies or fast-growth companies. The key for us as investors is to make sure that we value a company taking into consideration its growth rate and set up the capital structure that is consistent with what the company is trying to do in the long term.

In terms of measures, we don’t look at one thing. We look at, among other things, revenues, EBIT-DA, free cash flow, and return on capital. We have to look at all of the aspects of the business because they are all interrelated. You can certainly buy revenue and you can certainly buy market share, but at what cost? You need to understand at what cost you are generating revenue growth. Ultimately, it has to be a very balanced equation. The key is to capitalize the company in a manner that is right for it and not to over-leverage it to the extent that it may experience swings in business performance.

JONES: Those are good comments in terms of balancing the risk/reward, the growth, the capital structure, and all of the related elements. Berkshire tends to look a little bit more for growth because our predicting precisely what a company is going to do has proven over time to be more difficult than we would like to admit. So we try to make sure that there is a credible case for growth in the business so that we can grow our way out of troubles or misses from a projection standpoint. That is particularly important when you are looking forward and are not sure if you can count on the same kind of multiple expansion opportunities as we’ve all benefited from in this business over the last decade.

We tend to look at all of the different metrics. But a fundamental belief that the business we are investing in has some way to gain share or enter new markets is important so we can have confidence that the company will grow its way to increased value.

SCHAYE: One of the trends that we have seen that amplifies what you are saying is a concentration on organic growth as opposed to growth by acquisition. A lot of people thought they could generate growth just by buying more companies and doing a consolidation.

So a lot of people stuck their toes into consolidation as opposed to growing their businesses by a good solid management team with blocking and tackling and going back to the basics. Now they are going back to the basics and looking at good, strong base operations that can drive the business.

TENBROEK: That’s a good point. If you look back and pick your dozen private equity home runs, more often than not they are in industries that have good tailwinds and solid growth that allow you to build the business over five or 10 years to large values.

One qualifier that I always put on growth, though, and we as an industry are terrible at it, is that you need to be sure that in due diligence you are focusing on the industry that your company addresses. People often cite sector or industry growth rates when they should be focusing on specific products, services, or competitors. You have to be focused on the relevant customer base that is going to buy your company’s product or potentially would buy its product. It is amazing that growth niches can be found in what some people would consider “stagnant” industries.

JONES: You know that the industry definition is a little off when you are looking at a $50 million company that claims to dominant in a multi-billion dollar industry.

TAYLOR: At Advent we are looking for businesses in markets that are growing 5% to 15% organically. We want to see management teams that have demonstrated over a span of several years the ability to grow twice as fast as the market because they execute better, or because they have technology advantages or more efficient business models.

SCHAYE: I have seen a sort of fundamental shift. Five or six years ago everybody was saying they would combine companies, seek out cost savings, and not look at the top-line revenues so much. The earnings would come because they were going to squeeze it tighter. Now they are looking to get a good management team behind a good business.

TAYLOR: We have found over the years that certain businesses are easier to grow than others and, thus, we have really focused on how scalable the business is and how much operating leverage it has. If a business is scalable and has operating leverage, along with organic growth, you have the potential for rapid earnings growth. Attractive business models are important to us.

M&A: A lot of firms, like high-tech or new economy companies, used to be kind of out of bounds for private equity investment, but many have become more mainstream as the technology has been made obsolete or more commonplace. Are you looking at any of these companies and, if so, what are some of the sectors you are considering?

TSUSAKA: We have always focused on industries where we have expertise. That includes financial services, where we are very much focused on asset management and insurance and financial processing. We are also focused on outsourcing because we are big believers that companies will continue to look at their cost structures and outsource functions that are not core to their operations. As far as technology investments are concerned, we address that through our portfolio companies and avoid making direct, stand-alone technology bets.

In insurance, for example, we have spent several million dollars trying to build a new type of insurance adjuster exchange in a very fragmented industry. The space that our company plays in is a $30 billion-a-year market, of which 10% is outsourced. And 90% of that outsourced business is done by mom-and- pops. So our vision for creating an exchange is to take control of the fragmentation, institute standards, and run a lot of the business through the exchange.

SCHAYE: We have been focusing on what I would refer to as “dot.rust.” We look at those things that may support the infrastructure of technology as opposed to hard technology. It might be the person who is servicing the equipment in the switching center, such as outsourced technicians.

It goes back to the type of multiples that private equity firms want to pay. The high-tech arena is too risky in certain respects for the mature firms. This is not venture capital. The private equity firms are going back to the basics.

TAYLOR: We are already starting to see spinout opportunities from the large telecom and tech companies that have balance sheet problems. In all likelihood, they will spin out the under-performers first. So if you are going to consider these types of investments, you have to make sure that all of the good engineers haven’t left. In all likelihood, most of these spinout opportunities will be of companies that were acquired within the last few years.

Two years ago you couldn’t touch a spinout from a large tech or telecom company because it would either go the IPO route or be sold at such a high valuation that you couldn’t finance it. So going forward, spinouts should be an opportunity, but the challenge will be how to structure the deal. The revenue outlook for these tech spinouts will most likely be flat to negative for the next 12 to 18 months.

JONES: The challenge is to have a more specific understanding of the dynamics in these markets. For a while the telecom industry basically had free money available. Now this radical idea of actually having a profit model has come back into favor.

Berkshire has spent a fair amount of time hunting for opportunities in telecom. We have looked for infrastructure-related deals that have some cash flow Ñ thus we are staying away from the earlier-stage deals for the most part. We are working on something right now at a pretty advanced stage which meets our criteria. It’s a spinout from a parent company that can’t continue to focus in a certain region of the world right now.

TENBROEK: It is unfortunate that the public markets tend to ruin a lot of good industries. There is a period while the dust settles after the bloom comes off the rose in which you have companies that went public prematurely. They were good stand-alone companies, but their capital structures or expected growth rates are out of whack with what can actually be achieved.

Telecom is a good example. You have a number of companies that have pretty solid business models but they raised way too much debt and set expectations way too high. Unfortunately, we are going through a period of sobering up where there are going to be a lot of bankruptcies and rejuggling of capital structures, and, at the same time, a lot of equity owners are adjusting to the fact that their equity is worth a fraction of what they thought it was worth. It may be a while before deal activity picks up again.

Some companies that have pain are looking to spin off assets, and we have already seen a number of good spinouts. Often, they are divisions or companies that were bought just a few years earlier for five or 10 times more than what you are going to pay for them now.

M&A: A lot of companies across the economic spectrum are not doing well in this economy. Are you looking at some of these under-performers even though they may take more work and capital than most private equity targets?

SCHAYE: Some of the companies that we have been talking to and some of our clients are prepared to do that. But there still has to be some sort of attribute to make it attractive. If it has a good market share and some other worthwhile asset, and it’s not just in a bad market, someone may get in there and do the heavy lifting.

But if it is an across-the-board problem and the management is trying to revitalize it, that is not a place to go. However, if everybody else is doing well in the industry and you just have a dog of a company, there are people out there that will try to turn it around.

TSUSAKA: We are very much prepared to work on those. We know exactly the type of things that we like and we know where a lot of handholding is needed.

We like those situations because we are organized in such a fashion to really do only one or two deals a year and concentrate our portfolio. We are not looking to diversify our portfolio by any means. What that means is that you have to stick to the industries in which you have expertise and where you can bring direct, hands- on expertise.

TENBROEK: This is one of the areas where our strategy of bringing in a top-caliber CEO does play out pretty well. Everyone has good examples of strong industries where mediocre management can do a good job of building a company. When the industry is down and times are tough is when good management shines and mediocre management starts to struggle. When you are bringing in an outside management team, often you can create a lot of value by finding an underperformer.

We don’t like turnaround situations. That is not what we do. But if we can find an underperformer and bring in a team that can really take advantage of the situation, there is tremendous value that can be created.

You do have to be patient with this strategy Ñ plan on a four-to-six- year window to really create value and double or triple your EBIT-DA. We feel that the next four years are going to be great years for investing because the values are down. This is a good time to put money to work.

TSUSAKA: The key is that you have to differentiate yourself. There is a difference between an underperforming company and a distressed company. There is a reason why a company is distressed, and distressed investing is a very specialized field requiring a certain skill set.

TAYLOR: We spend a lot of time on our portfolio companies. When you look at growth businesses that will double in size, you run into operational challenges as well. During rapid growth you need to reinvent operational processes, invest in systems and strengthen management teams. So whether you are investing in an undermanaged business or a well-managed fast growing business, you must spend a lot of time with your portfolio companies.

At Advent, we are sector-focused. Our sectors include business services, financial services, specialty retail, and technology. We have been seeing a lot of good companies in the business services and financial services areas; both of these sectors are doing pretty well. In specialty retail and in tech – both sectors that are currently somewhat out of favor – we think it is an attractive time to invest. During the late ’90s we kept asking, “When is the economy going to slow down?” It is hard to go into a retailing deal when you are buying off of peak earnings. Right now, you have the benefit of entering the specialty retail sector near the bottom of the economic cycle, which is better than starting off at the top. So we are spending significant time in this sector as well.

Technology is similar. The outlook for technology sales and earnings for the next 12 to 18 months is not great, but we are willing to look at profitable technology companies with strong long-term fundamentals, even if the near-term growth prospects are weak.

JONES: I guess we all have to deal with distressed companies to the degree that we have any kind of existing portfolio. Berkshire has looked for basically good companies that may have a bad balance sheet. If you know of a financial sponsor that is worn out with a decent but underperforming company or a sponsor that wants to find somebody else to bring in some new capital and some new blood, let us know and we’ll look at that.

M&A: There was a big burst of going-private deals last year Ñ companies that aren’t bad performers but can’t get a decent stock price. How do you feel about them? Do they involve any special problems or opportunities?

TSUSAKA: There are a lot of public companies that ought to be private companies. The problem is that stock prices have fallen from their highs and it is hard for boards and CEOs to accept the fact that their stock is trading at 20 cents on the dollar from its highs and to do a transaction that is valued lower than what they perceive the value to be.

But the reality is that if they thought long and hard about it, they would realize they are better served as a private company. We will probably begin to see more private deals next year if the economy continues to move sideways and the stock market does the same.

JONES: It has been an interesting change. In 2000 we privatized U.S. Can. At the time, the slower-growth companies were looking at the crazy multiples being offered to the more growth-oriented companies. There was some jealously. Now there is another dynamic where everybody is trading at lower values.

But I think you still have this waiting it out attitude because of expectations on what values should be. It takes some time for people to readjust, and the financing markets won’t help right now. It is generally a tougher process to buy a company in a public environment. It is not for the faint-hearted.

M&A: Generally speaking, what is the lending climate right now? Is there any correlation with the Fed’s bringing down interest rates? Are there any special rules or criteria that are being applied as far as multiples or covenants are concerned?

SCHAYE: I can sum up the lending market in two words: It stinks! The leverage hasn’t been this tight in probably the last eight years. And because of the consolidation of banking, they only go after so many people these days. It is very, very difficult. There is tighter leverage, capital calls are being built into deals, and mezzanine financing is ever so hard to get. Again, there are fewer players in the business so there are fewer and fewer deals you can lock onto. It is just that much harder to get deals done.

TENBROEK: Multiples are down to a point where you’ve reached the asset-based loan to cash flow loan crossover. In a lot of cases, it is easier to get an asset-based loan, and the banks are more comfortable giving them. So we are seeing more asset-based loans and in companies that aren’t even particularly asset-intensive.

There are pluses and minuses to asset-based loans. Of course you have a gap that you have to fill somehow, with sub-debt or another form of capital. The market has responded with a senior preferred equity strip, typically targeting returns in the 25% range.

M&A: Do you consider that part of the mezzanine strip?

TENBROEK: No, this is not a debt instrument, otherwise senior lenders tend to factor it into the total debt cap, which has come down. Mezzanine debt is still the standard sub-debt with a 12% to 14% current coupon, tax deductible interest, and so forth. The senior preferred equity strip is an accruing piece of the structure, typically with a 12% to 16% accruing dividend and a bigger piece of equity than sub-debt. It’s typically offered by insurance companies, though some non-control equity investors are getting into the area as well.

SCHAYE: It doesn’t come cheap.

TSUSAKA: I think the big U.S. money center banks were pretending to be in the business for the past six months. On occasion you would see a large deal get done as well as relationship-driven deals. But the truth be told, it doesn’t matter where interest rates are; the liquidity we have enjoyed in the past several years is not there. Until we get the liquidity back into the system there will be repercussions in the stock market as well. There is just not a lot of money flowing. There is a lot of con- traction at this point.

JONES: Because of consolidation among financial institutions, you have fewer doors to knock on. There are fewer banks, and to make matters worse, they want to hold less exposure.

So there is a lot more thinking required in terms of how you will get a deal done, particularly the smaller, middle-market deal where you don’t have the loan size that it takes to really attract some of the more structured fund buyers. It is tough. You can see that fact statistically through the way the total leverage multiples have been coming down over the last year to under four times total debt-to-EBIT-DA on average.

TSUSAKA: The math doesn’t work. You can only get 3.9 times total debt and you bought the company at seven times and put in a whole lot in terms of equity. So this company had better be growing at 20% with strong EBITDA margins.

TAYLOR: In the middle market there are not a lot of players to whom you can syndicate your loans. So to get a deal syndicated, you must support the lead bank’s efforts a lot more than you did in the past. I think that as long as we have a weak economy, the banks are going to be tight. M&A: In this particular environment, haw important is the mezzanine?

SCHAYE: It is still a necessary component. You can only put so much equity in and still get the returns you need. Though it is high-cost, it is a force that has to be dealt with. You have to use mezzanine or you are just not going to get the returns.

TSUSAKA: I don’t find the mezzanine to be scarce. I think the common factor is that it is expensive. It is there, but it comes at a cost.

TAYLOR: We tend not to utilize maximum leverage in our transactions because we are focused on growing the business. Many of our deals require only equity and senior debt.

If you buy 30% to 70% of a company in a recap, most of the time you don’t need the mezzanine strip. It is expensive capital today.

TENBROEK: People thought this was supposed to be the golden age of mezzanine. They thought that the growing gap that was created between purchase price and senior debt would be filled with mezzanine. The reality is that the total debt covenant has been coming down as well.

So there is not a widening slot in there for mezzanine. It is still staying fairly small, in the 1.25 times to 1.5 times EBIT-DA range. The slowing down of the deal flow is really hitting the mezzanine players harder than I think they expected. A number of mezzanine players got few deals done last year.

M&A: What in general are the average or median levels of pricing and how has this changed over the last year?

JONES: Over the last two plus years, there has been a decline from peak purchase price multiples of 7.5 to 8 eight times EBIT-DA to six or less times EBIT-DA. It is interesting that we did see a lag between the decline in lending multiples and the impact on purchase prices. For a little while, as banks got more concerned about their loan portfolios, equity was filling the gap; optimism continued to drive the equity side. But now, a higher level of concern and conservatism has moved all the way down the balance sheet.