S&P Downgrade Causes Stress and Opportunity in M&A

The S&P downgrade of U.S. debt has caused the markets to dive and produced fears of a double dip. But for some PE execs and bankers, the downgrade means one thing: opportunity.

Many PE execs brushed off the effects of the downgrade. “The downgrade doesn’t make a hill of beans of difference,” says one buyout exec.

“The downgrade is more psychological than anything,” another added.

“It will have no effect except to the extent that debt markets are already tightening,” a third PE exec says.

The downgrade will definitely affect sellers or those looking to exit in the near term, the first buyout exec says. “If you have something in the market right now, and you have buyers thinking the world will potentially end, it’s very easy for that buyer to reassess and not close a deal,” says the exec, who focuses on larger transactions. “This can throw a lot of process for a loop.”

This uncertainty could also lead to lower prices for buyers and better outcomes for those that have leverage, the exec says. “This is good for buyers but not so good for sellers,” the source says.

The second PE exec, who focuses on middle market deals, says volatility in the equity capital markets is creating “distress, confusion and opportunity.” The source pointed to Warren Buffett’s $3.25 billion offer for Transatlanic, which is below the reinsurer’s book value, as an opportunistic play in a confused market.

Several PE and banking sources say it’s too soon to tell how the downgrade will affect deals. The real test will come after Labor Day when several deals are scheduled to launch.

The S&P downgrade is exacerbating a disconnect that exists between equity investors and the credit markets, a fourth PE exec says. The credit markets, the source says, are very aggressive right now and offering to lend at rates of 5-6x EBITDA. But banks have one caveat: they want PE firms to invest 40% equity in deals. This means the PE firms are being forced to buy companies at 9-10x EBITDA.

“You can’t get equity returns on 10x EBITDA unless there is significant growth in the business,” the exec says. “With the S&P downgrade, it’s hard to be optimistic about revenue growth. This just exacerbates everything.”

However, the downgrade is not causing the slowdown in deals right now. Several PE and banking sources say the lack of M&A is due to the August slowdown. Typically, bankers and PE execs go on vacation this month and into early September. This causes deals to get pushed back until after Labor Day.

“I’m not seeing any deals get pulled yet,” says a fifth PE exec. The source says their firm is currently in the market with a “live financing” of a club deal and “it held together last week.”

Another banker says they expect to have a “very large number of deals” coming to market after the summer break “assuming that the markets hold together.”

“Washington–in particular the White House– needs to start showing some leadership and not just another stimulus or a QE3,” the banker says.