G.P.s Shrug Off Slow Deal Volume In Second Quarter –

It’s the case of the missing deals.

Most second-quarter indicators pointed to a robust deal market, with general partners claiming strong flow and lenders expressing eagerness to finance. The buyout industry, sources say, has been confidently emerging from last September’s credit market “blip,” and activity has since been stabilizing.

So where were the deals?

The total transaction value of all buyouts completed in the second quarter weighs in at just $7.605 billion-according to BUYOUTS and Thomson Financial Securities Data. This is more than last year’s fourth quarter-the quarter of the infamous blip, which saw $4.843 billion worth of buyout activity. However, it is less than the first quarter, with $8.296 billion in deals. And it certainly is less than 1998’s second quarter, which stood at $15.957 billion-the decade’s record quarter for buyout deals.

Most industry sources were reluctant to speculate on why deal activity slowed in the second quarter. The most frequent response-it’s a coincidence. Deal flow is healthy, sources say, with companies like Browning-Ferris Industries and Patriot American Hospitality slated to receive massive capital injections from buyout groups. But it just so happens that a number of large transactions closed in the first quarter, and the next group of big ones is slated to close in the third quarter, leaving the second quarter a mega-deal flyover zone. The relative calm, says Dan Blanks, a managing director at Hicks, Muse, Tate & Furst Inc., is not necessarily a sign of a struggling deal market. “This is really a function of the fact that the business comes in kicks and starts,” Mr. Blanks says.

Other explanations include a timidity in the high-yield market prompted by fears of interest rate hikes and company valuations lofty enough to make even seasoned general partners queasy.

But with so many huge deals in the pipeline, and with the middle market still showing signs of life, most observers predict the second quarter of 1999 will be remembered as the calm before a storm of buyout activity.

If the big gorillas are cautiously plotting their next big move, as evidenced by the dearth of billion-plus deals, buyout firms in the middle and small-deal markets have seen decent activity.

Most sources attribute the less-than-impressive total deal values for the second quarter to the lack of mega-deals that actually managed to close. Madison Dearborn Partners gets the prize for the quarter’s only billion-plus deal with the acquisition of Packaging Corp. of America, the packaging board division of Tenneco. The Chicago firm put $200 million in equity into the $2.3 billion buyout. Tenneco will retain 45% of the company, according to terms of the deal.

Sam Mencoff, the Madison Dearborn managing director who led the transaction, says everything about the Packaging Corp. deal went smoothly, especially in relation to the financing market, which he described as very receptive. J.P. Morgan & Co. and Deutsche Bank (formerly BT Alex. Brown & Co.) provided senior debt, as well as high-yield financing at 9.625%, which Mr. Mencoff says was lower than Madison Dearborn expected.

The deal went so well, Mr. Mencoff says, he has no idea why other large buyout groups did not join the party with big deals of their own. In fact, it may be that other large firms will just be fashionably late rather than no-shows. As is well known to heavy hitters like Apollo Advisors, The Blackstone Group and Thomas H. Lee Co., there still are billions of dollars in buyout deals waiting to be closed.

For example, Apollo and a syndicate of other buyout groups including Blackstone have agreed to partner with Allied Waste Industries to acquire Browning-Ferris, a waste management company, for approximately $9.05 billion. Should it close, this deal would go down as the decade’s largest buyout. Also just around the corner is the $3.5 billion investment in Patriot American by Apollo and Thomas H. Lee Co. Should these two deals close in the next three months, they would push the third quarter into record territory.

High Prices Give Pause

Despite the large transaction values of these deals, however, it should be noted that the buyout firms involved are participating as minority investors, a trend among firms with multi-billion dollar funds indicating a desire among G.P.s to look for ways to skirt the high prices in the deal market.

“There’s no denying that a lot of companies are being shown around the market at pretty rich valuations, and that’s had an effect,” Hicks Muse’s Mr. Blanks says.

The steep valuations in manufacturing-once a bread-and-butter sector for U.S. leveraged buyouts-has sent general partners and limited partners increasingly in search of lower prices in Europe and Asia, the latter of which saw a surge in funds coming to market in the second quarter (BUYOUTS June 21, p. 1). Firms like Hicks Muse, currently raising a $1.5 billion Europe fund, are finding large deals more readily across the pond. The firm agreed last quarter to pay GBP870 million to acquire food and furniture company Hillsdown Holdings PLC (see story, p. 14). Likewise, Texas Pacific Group reportedly spent approximately $800 million to acquire 70% of Punch Taverns, an operator of pubs in the U.K. that itself is expected to soon bid $4 billion for Allied Domecq PLC, another pubs business.

L.P.s also are betting that buyouts in the maturing technology sector will offer bargains. This belief was emphasized by the rush to join the new Silver Lake Partners LLC technology buyout fund (BUYOUTS May 31, p. 1), which managed to round up $1.8 billion in spite of it being the first time its partners have worked together. Should good deals in the customary stomping grounds of buyout firms continue to be elusive, further migration abroad and to non-traditional sectors is expected.

If the big gorillas are cautiously plotting their next big move, as evidenced by the dearth of billion-plus deals, buyout firms in the middle and small-deal markets have seen decent activity. The numbers are still down, though-the second quarter saw just $1.68 billion in activity for deals valued at less than $250 million, compared with $2.84 billion for the same category in the first quarter.

“There’s no denying that a lot of companies are being shown around the market at pretty rich valuations, and that’s had an effect,” Hicks Muse’s Dan Blanks says.

Nevertheless, general partners who focus on the middle market are nothing but optimistic. Steve Graham, senior managing principal at Graham Partners, says good values currently can be found in the middle market, and financing is readily available. Mr. Graham says family businesses, in particular, increasingly are seeking to cash in on years of hard work now that the capital markets have returned to health and the deal market is perceived as being sharply in the seller’s favor.

Many lenders echo these comments. David Rudis, an executive vice president at LaSalle Capital Group, says he has seen increased momentum from entrepreneurs seeking liquidity, and financial buyers are equally motivated. “The pipeline is as strong as it was anytime last year, pre-September,” he says. “Perhaps stronger.”

Public Market Bargains to Be Found

Even in the public markets, industry sources say middle-market bargains can be found. Phil Strauss, an executive vice president at Fleet Capital Corp., says his firm has three or four deals in the works that involve public-to-private transactions for publicly traded mid-cap manufacturing firms, which he describes as undervalued. Mr. Strauss points to recently signed deals-including Littlejohn & Co. LLC’s $97 million buyout of Durakon Industries Inc. and E.M. Warburg, Pincus & Co.’s $496 million buyout of Knoll Inc.-as further examples of the sort of activity he expects to see with greater frequency in the coming months.

Most lenders say the multiples of EBITDA at which they are willing to commit senior debt has stabilized around 3.5.

In the high-yield market, however, some market observers see signs of instability and note that the threat of interest rate increases has affected the capital structure of some deals.

High-Yield Still Hard Hit

In Joseph Littlejohn & Levy’s $740 million buyout of MCII Holdings (USA) (see story, p. 18), for which CIBC World Markets provided high-yield debt, CIBC lowered its originally proposed $200 million high-yield offering to $150 million. The reason, says Richard Hassard, a managing director at CIBC, had to do with the outflow of capital from high-yield mutual funds, which was prompted by fear that the Federal Reserve Bank will raise interest rates.

With so many huge deals in the pipeline, and with the middle market still showing signs of life, most observers predict the second quarter of 1999 will be remembered as the calm before a storm of buyout activity.

The one explanation for the second- quarter deal dearth general partners and lenders did not give was that private equity investing has reached an impasse; that the old saw about too much money chasing too few deals finally has reached critical mass. The gloomiest description of the second quarter was that the market had stabilized and was “normal.” After all, say most G.P.s, the second-quarter statistics only take a snap-shot of a market in transition and do not give an accurate reading of what the coming quarters will bring. Mr. Blanks agrees: “I, for one, would not take [the deal slowdown] as a harbinger of very slow activity in the time to come.”