Over the past two months, as the liquidity crunch in the debt market has taken hold, some headlines have been predicting the death of the management buyout.
The argument goes that investment banks have many billions in debt on their balance sheets, which they now cannot syndicate so that, given that private equity typically relies on high levels of leverage, the debt system is so choked that it is now impossible for private equity firms to complete deals. However, reports of the death of private equity deals have been exaggerated.
While the situation is still changing, what appears to be happening is that the liquidity crunch has resulted only in the private equity deals in the £500m-plus bracket struggling to find any acceptable finance.
Deals worth less than £500m still seem to be flowing, albeit with a reassessment of risk by the banks and a change in pricing. Sub £500m mid-market deals have completed despite the turbulence – for example the investment by Phoenix Equity Partners in Musto, a deal which completed in mid-August when the market was at its most uncertain point to date. Others are in the pipeline, including the expected sale of Pret A Manger for around £400m.
Even in the mid-market, now that banks have a heightened awareness of risk the impact is generally that the frothy lending terms that were available before the summer have now gone: debt multiples are reducing, pricing is hardening, covenants are more rigorous and deals involving businesses that are less mature and stable may indeed struggle to find lenders at all.
For larger lends, where banks would have once been comfortable syndicating post-deal, they are far more likely now to club the deal up front. As debt multiples come down, this in turn will affect pricing as, with reduced leverage, private equity buyers can no longer make acceptable returns at higher price points.
Resolving this mismatch of pricing expectations between buyer and seller, coupled with a more difficult process with the lenders, means that we are now in a period in which deals that do complete are likely to take longer on average to do so compared with the aggressively timetabled auction processes earlier in the year. However, many private equity firms welcome prices coming down, even though it also impacts on their sales of existing portfolio companies.
The impact of the credit crunch is still causing unexpected shocks to the economy, the latest and most high profile being the run on Northern Rock. Hopefully that will be the last major impact, but it is unlikely that all the landmines resulting from the sub-prime debt problem that triggered the liquidity crunch have been found.
If they have been then the situation may improve and the very strong sellers market that has existed may return next year, albeit probably without some of the most aggressive terms from lenders that signalled the top of the market.
However, in a worst-case scenario the ultimate impact could be that increased borrowing costs across the economy will impact on house prices, consumer confidence and industrial productivity to bring on a recession. If that happens then the current slowdown in large deal activity could easily spread through to the mid-market and below.
This worst-case scenario may well yet be avoided and, even if it does come to pass, it must always be remembered that the private equity firms themselves have raised many billions of pounds on the basis that this will be invested over the next five years at most: in these circumstances, even if there is a temporary slowdown in the volume of M&A deals completed by private equity firms, it cannot be too long before they must return to the market to deploy the capital raised by their funds. Private equity is now an institutionalised part of the M&A market – it is very far from the end of the road.