Overshadowing any regulatory or judicial developments in cross-border international M&A in the summer of 2007 has been the rapid and dramatic loss of leverage in the LBO markets. Just as the federal government and some senior and influential business leaders have lamented the hollowing-out of public corporate Canada through take-private acquisitions, many by foreign entities, it seems clear that any potential regulatory response would be addressing yesterday’s problem. The markets have already effectively closed the barn door after some of the largest target horses have left for greener pastures, at least for the time being.
Fuelling the unprecedented volume and size of transactions in Canada, as in the U.S., has been the relentless drive of financial buyers (as compared to strategic industry buyers who have also been active, particularly in natural resources) in takeover activity. The record closings of new vintage private equity buyout funds, coupled with dry powder from prior vintage buyouts, has meant an insatiable demand in money terms on the buy side of the equation, coinciding with continued strong fundamentals on the sell side.
However the equity component has only been the tip of the iceberg. Throwing additional fuel on the fire has been the ability to leverage that equity with cheap, covenant-lite debt, adding an unsustainable frothiness to M&A markets. It leads one to legitimately ask whether the drying up of the CDO and CLO markets on the heels of the sub-prime debacle means that “the party is over” or whether the drunken binge is merely taking a market-correction breather. After all, many sage commentators have for some time been predicting that correction on the basis that acquisition debt has been under-priced for the risk for far too long.
What is of more immediate concern than the duration of the debt-fuelled drought is the immediate impact of the current loss of leverage on deal making. Some preliminary observations:
1. The rapidity of the change from “hot, hot, hot” to “the big chill” in a matter of weeks has left a number of multiple billion dollar deals in financing limbo. The inability of the financing banks to parcel out and distribute buyout debt has meant that bridge commitments have been availed. Even where unconditional financing commitments have meant that banks have had to legally step up to the plate, some financial sponsors and targets have consensually agreed to top up the equity component and reduce leverage multiples, perhaps recognizing the fear that otherwise they may be killing the goose which has been laying golden eggs for some time now.
2. To continue the metaphor, dividend recaps are, at least for the foreseeable short term, a dead duck. This loss of adrenalin kick to buyout performance returns may have a chilling effect on new money coming into the space but the juggernaut of pension fund money looking for risk-adjusted returns above public market investments may suggest this is a temporary phenomenon, with a return to more traditional financing covenants and higher margins self correcting the problem.
3. It would appear that the anticipated take-over bid premium which has been building in the North American public stock markets has, to some extent, been squeezed out in recent weeks with market declines causing some havoc for hedge funds. Of course this has meant an opportunity for private equity firms who have lost the performance enhancing magic of leverage to counter, to some small extent, with an ability to buy more cheaply in the first place.
4. On the sell side, the glee which has accompanied the build up to ever higher EBITDA multiples, may have crested. Even though target balance sheets remain healthy and fundamentals remain strong, the disappearance of cheap and abundant debt will affect the modelling of what is a reasonable multiple downward.
5. Lesser leveraged deals in the mid-market will certainly be less affected and the ability of strategic buyers to compete more effectively with the financial sponsor giants, in the large deal segment, will likely increase.
It will be interesting over the course of the second half of 2007 to observe whether the loss of leverage and consequent impact on deal making, particularly in the LBO driven market, will be temporary or more longer term. Cash has been king in contested take-overs and take privates for some time, but the changes in the source of that cash, namely cheap and abundant debt, is likely more than short-lived, at least while investor confidence remains shaken even in the face of continued strong fundamentals.