After a Cold Start, 1Q Deal Market Begins to Thaw Out –

Don’t call it a comeback. Yet.

Compared with the jittery performance of last year’s second half, 1999’s deal market looks promising. But compared to the sizzling first quarter of 1998, this year’s first quarter seems to be merely simmering.

While last year’s private equity deal makers leapt from the starting blocks with reams of money and a seemingly cavalier attitude toward high valuations, this year’s market atmosphere can best be described as starting out confident but cautious.

The first quarter of 1999 saw buyout groups close 81 deals-47 of which had disclosed values totaling $8.296 billion, according to BUYOUTS and Securities Data Co. This total contrasts markedly with 1998’s first quarter, which saw 82 deals close, valued at $11.537 billion-a first-quarter record. But 1999’s first quarter also represents a return to health in the deal market, which continues to strengthen after reaching a low of less than $5 billion during 1998’s fourth-quarter “blip.”

1999-A Return to the Normal

It is hard to find general partners who don’t have nice things to say about the quarter just past and the year ahead. Most refer to the early-Autumn credit troubles as a temporary logjam in an otherwise smoothly flowing deal market. The spirit was willing, they say, but the debt markets were weak. Now financing is back and the approximately $60 billion (according to Venture Economics Information Services [BUYOUTS Feb. 22, p. 44]) of uninvested buyout capital can be put to work.

“There has been a renewed liquidity from financing sources,” says Stephen Schwarzman, the president and chief executive officer of The Blackstone Group. “What we’ve seen in the first quarter should continue, as long as the basic drivers of the economy stay in place.”

Cautious optimism for the coming year spans the buyout world, from private equity behemoths like Blackstone to middle-market firms like Weiss, Peck & Greer. “Our deal-flow opportunities have been strong,” says Peter Pfister, a managing director at New York-based Weiss Peck. “It feels like the bank market has come back, but not to the lofty levels we’ve seen previously.”

“There’s enough private equity money out there that it’s very tough to get good values on a straight buyout.”

Indeed, the deal-flow slowdown in last year’s third and fourth quarters was mostly the result of an austerity regime handed down by the lending community. This same community is now easing up on credit, but lenders say G.P.s should not expect a return to the fast and loose days of a year ago.

“A lot of the uncertainty [in the debt markets] has subsided,” says Attila Koc, a senior vice president at Credit Lyonnais. “But the deal flow isn’t super robust. It’s nowhere near where it was in the first quarter of 1998.”

Mr. Koc adds that since the credit freeze, banks have begun to focus more on returns, which includes finding additional business with buyout firms beyond plain-vanilla senior financing. “The lending community is looking at relationships more than just product. They want swaps and fees,” he says. “They’re thinking, Okay, maybe I’ll get some ancillary banking business down the line.'”

This focus on returns has made lenders reluctant to work with private equity groups who likely will not buy additional bank products.

However, in spite of the increased caution, banks are starting to finance deals that four months ago they would have shunned. One sign of this is the increased activity in the 144-A market. Deals in the first quarter ranging in size from middle-market to mega-deals were financed with high-yield offerings (BUYOUTS March 22, p. 4). According to Michael Miller, the head of high-yield sales at ABN-Amro Bank, a total of $20.5 billion in high-yield bonds has been issued in 1999, compared with $27.6 billion during the same period last year.

The gradual re-opening of the high-yield market is a welcome development for G.P.s. Banks are still lending on multiples of three to 3.5 times EBITDA, sources say, while sellers will not accept less than a multiple of six times EBITDA. Without a healthy high-yield market, buyout firms would be forced to fill the gap with more equity-already at historic levels early last quarter-or risk losing out on deals.

A Quarter of What-Ifs

Official numbers notwithstanding, the first quarter could have been a contender-that is, there were a number of deals that almost occurred that would have put the quarter into record territory.

* Blackstone came disappointingly close to acquiring an autoparts division of United Technologies for $2.25 billion, which would have been the firm’s biggest deal ever; however, strategic buyer Lear Corp. spoiled the wedding at the last minute by outbidding Blackstone’s best offer by $50 million.

* Hicks, Muse, Tate & Furst Inc. backed out of a deal to buy two divisions of Simon & Schuster for $860 million. It also passed on its offer to buy oil concern Coho Energy for approximately $250 million.

* Although it did not close in the first quarter, the $2 billion acquisition of Tenneco’s packaging board business by Madison Dearborn Partners was inked in February. Should the deal close, Tenneco will retain 45% of the new company.

* Also inked this quarter, but not likely to close until midyear, was the decade’s biggest buyout-the $9.05 billion acquisition of Browning-Ferris Industries by Allied Waste Industries with the help of Apollo Advisors and a slew of other buyout groups including Blackstone, DLJ Merchant Banking Partners and Greenwich Street Capital Partners.

This deal clearly illustrates three trends that are emerging in 1999-buyout firms’ increasing partnership with strategic buyers, their increased co-investing with other buyout firms, and the return of the high-yield market: the deal will be financed in part by a $1 billion high-yield offering (BUYOUTS March 22, p. 1).

G.P.s Catch Co-Investing Fever

The first quarter saw two mega-deals close, which, while not especially impressive for their size, were structured in a way that points to a trend of buyout groups increasingly co-investing in large transactions, sources say.

First came Blackstone’s partnership with Welsh, Carson, Anderson & Stowe to buy Centennial Cellular Corp. for $1.5 billion (BUYOUTS Feb. 8, p. 12). After being signed in the fourth quarter, the deal finally closed in the first quarter, going through several structural mutations along the way owing to the debt and stock market collapse. In an unprecedented move, the two buyout giants and loan syndicator Merrill Lynch & Co. agreed to waive a material adverse conditions (MAC) clause on the bridge financing. The MAC waiver agreement is significant in that it sets a new standard of risk which private equity groups and lenders are willing to assume in order to close deals.

Then came Blackstone’s $1.25 billion buyout of cable company Bresnan Communications in partnership with strategic buyer TCI Communications and the management of Bresnan. Blackstone ended up with 40% of the company, while its strategic co-investor bought 50%.

Even the largest non-mega-deal was structured with co-investors-DLJ Merchant Banking Partners, Madison Dearborn Partners and private investment firm Eagle River teamed up to buy wireless service provider Nextel Partners for $990 million. The trio of investors committed $156 million to the deal and raised $406 million in 144-A financing.

Industry observers say the co-investment approach is one way to diminish the sting of high valuations in the deal market, which no one sees abating any time soon.

“There’s enough private equity money out there that it’s very tough to get good values on a straight buyout,” says Howard Lipson, a partner at Blackstone.

“A lot of the uncertainty [in the debt markets] has subsided. But the deal flow isn’t super robust. It’s nowhere near where it was in the first quarter of 1998.”

In addition, a robust initial public offering market has made strategic sellers more interested in partnering with buyout firms. “The IPO cycle has gotten shorter,” says David Mussafer, a managing director at Advent International. “Corporations can see, in the near term, the possibility of an IPO, so they are prepared to hold larger stakes now. They see the opportunity for making more money.”

Advent recently closed a $125 million recapitalization of financial services company Dollar Express, in which Dollar Express kept an interest of slightly less than 50%. Mr. Mussafer attributes Dollar Express’s desire to maintain interest in the company to Advent’s proclivity for IPOs. The firm completed its 100th late last year.

The same mentality holds with the Nextel Partners deal-parent company NEXTEL Communications maintains a 33% interest in the spin-off on the anticiptation of an immenent IPO.

In the first quarter, buyout firms also sought to find better-priced deals by taking minority stakes in publicly traded companies. Thomas H. Lee Co. used a whopping $300 million in equity to purchase 28.7% of Metris Cos., a credit card business. Hicks Muse last month shelled out $250 million for a 9% stake in cable concern RCN Corp. (see story, p. 12).

Co-investing and the acquisition of minority stakes in public companies likely will continue into the next quarter, sources say. Already Thomas H. Lee Co. has agreed to join with Apollo Advisors to buy a 29% stake in Patriot American Hospitality for $700 million in equity.

Few market observers saw any surprising developments in the first quarter, and few predicted sweeping changes in the near future. The robust public markets and competition with strategic buyers will continue to buttress valuations, they say.

“Pricing is very high,” says Steven Koch, co-head of mergers and acquisitions at Credit Suisse First Boston. “The challenge for the buyout shops in this market environment is you have a very active and healthy strategic buyer market, and that ain’t going to change. For the strategics to get weaker, you’d need a drop in the equity markets.”

Still, the appetite for deals appears unabated as buyout firms roll into the second quarter. The trouble in the credit markets is past, say G.P.s, and the opportunities to do deals are about the same as they were before the early-Autumn freeze.

“That [credit freeze] period had more of an implication for getting deals done, but it didn’t interrupt the deal flow,” says Bruce MacRae, a partner at Boston-based buyout firm Parthenon Capital. “It may have only drawn things out a bit.”