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The Perfect Storm
Three converging market trends have created a unique window of opportunity in corporate finance—for buyers and sellers alike:
- A flood of liquidity from the Federal Reserve, pushing debt capital costs lower than they've been in years
- Strong activity in the corporate finance, M&A and private equity markets due to greater revenue and profit visibility
- Increased competition among private equity firms
What's the upshot? Companies seeking recapitalization or acquisition should stay alert to these changing market dynamics.
Debt Market Leading the Way
The clear driver of today's increased number of private equity transactions has been the revitalization of the debt markets as a consequence of three related forces:
- Increased overall liquidity
- Increased leverage multiples
- Decreased cost of capital
Even with the not so distant memories of the unprecedented level of bankruptcies in 2001 and 2002, banks have come back with a vengeance in terms of lending money.
The secured (senior) lenders have awakened from a three-year slumber and pushed average senior debt multiples to 3.3x EBITDA by mid 2004 from 2.2x EBITDA back in 2001 (see chart below). Asset-based lenders are also getting more aggressive with "tranche B" or "second lien" financing to increase total secured debt packages by another 10-20%. For the private equity markets, cash flow lending is still king, but asset-based lenders have started to play more actively once again, especially in turnaround and bankruptcy-related financing. Also, non-traditional forms of secured financings continue to see aggressive expansion with financings tied to maintenance contracts, intellectual property and other non-traditional assets.
The unsecured debt markets have encountered even more sizzle as a substantial supply of leveraged capital has provided the impetus for aggressive lending. Mezzanine debt has come under competitive pressure as many new entrants, most notably hedge funds, have entered the debt market. These players have had a competitive effect in driving the cost of capital down substantially. In addition, the high-yield markets have provided further competition as market dynamics have driven the cost of capital below 10% for the first time since 1997. Finally, venture lending has returned as many private companies are utilizing the debt markets as a low-cost mezzanine financing source that is both dilution-friendly and quick to close.
Momentum in M&A, Venture Capital and Private Equity Buyouts
Metrics across the capital markets have also been trending positively with all transaction categories enjoying the benefits of a white-hot debt market. The first half of 2004 showed continued improvement across our three primary transaction markets of corporate M&A, venture capital and private equity buyouts. For the overall M&A market, there were 4,284 announced transactions totaling $511 billion in the first half of 2004 versus 4,166 transactions totaling $227 billion for the same period in 2003. Year to date, the venture capital market has also seen continued progress with 1,311 deals for nearly $13 billion in financing, up from 1,251 and $10 billion YTD for 2003. Rounding out the triple play, the private equity market saw a 26% increase over the same period a year ago with $29.6 billion in deal volume.
Unprecedented Competition in Private Equity
Perhaps most interestingly, we're seeing unprecedented competition within the private equity markets. As little as two years ago, financial buyers couldn't offer a price high enough to entice sellers in a competitive process. The increase in average debt multiples from 3x in 2002 to 4.9x in 2004 has allowed private equity buyers and corporate sellers to bridge the valuation gap and complete transactions otherwise unobtainable. In some cases, leverage markets have allowed private equity buyers to be more competitive than strategic buyers with an average 1.1x premium in private equity buyouts over strategic transactions in the middle market.
Even greater evidence to the competitiveness of private equity buyers comes in situations where private equity firms sell a portfolio company to another private equity buyer, "trading up". One recent example is a $250 million deal between Windward Capital and GTCR Golder Rauner for transaction processor Retriever Payment Systems. Retriever gained its independence from First National Bank of Omaha back in 2001 through a management-led buyout backed by Windward Capital. Due to a complement in GTCR's portfolio and the favorable debt markets, they were able to outbid the strategic buyers for the company and win the deal.
How Long Before the Music Stops?
There is a tremendous near-term opportunity for private and public companies to build value through various debt financings. Debt financing can be tailored to almost every imaginable business and transaction situation, offering flexibility and breadth of liquidity opportunities for private company owners in dividend recaps and other liquidity financings even without a majority equity transaction. Similarly, in terms of M&A transactions, acquisitive private companies have an opportunity to approach strategic M&A through more complex leverage structures.
Despite the performance of the debt markets in the first half of 2004, no one is sure how much longer this will last before the music stops. Uncertainty abounds. The looming presidential election and the situation in Iraq could suppress the current capital market activity. It's an unusual confluence of circumstances, to be sure. Where there is change, there is opportunity.
Read about Cascadia Capital's investment banking services.
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Cascadia Capital is a national investment bank offering corporate finance, mergers & acquisitions, strategic advisory services, and capital market services to companies across North America. From its Seattle and New York offices, Cascadia Capital serves emerging growth and middle market companies, both public and private. The firm has an established track record in the following sectors: Information Technology, Communications, Security & Defense, Healthcare, and Industrial & Consumer. The firm recently established a Financial Sponsors group to more fully address the needs of the private equity community. In the past 18 months, Cascadia Capital has closed 25 transactions totaling more than $500 million.
Read more about Cascadia Capital and its approach.
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Graph Source: Portfolio Management Data; The Wall Street Journal and Gold Sheets Daily Other Sources: Mergerstat; VentureWire, 07/19/2004; Buyouts Newsletter, June 21, 2004; Fleet Capital Market Flash, March 2004 and Bank of America Business Capital Market Flash, April 27, 2004
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