Download Article by Nicholas Dietrich of Gowlings expanding on comments

“THE BIG ELEPHANT IN THE ROOM: THE IMPACT OF THE
RAPID LOSS OF LEVERAGE IN THE SUMMER OF 2007”
Nicholas Dietrich
Gowling Lafleur Henderson LLP
Overshadowing any regulatory or judicial developments in cross-border international
M&A in the summer of 2007 has been the rapid and dramatic loss of leverage in the LBO
markets. Just as the federal government and some senior and influential business leaders have
lamented the hollowing-out of public corporate Canada through take-private acquisitions, many
by foreign entities, it seems clear that any potential regulatory response would be addressing
yesterday’s problem. The markets have already effectively closed the barn door after some of
the largest target horses have left for greener pastures, at least for the time being.
Fuelling the unprecedented volume and size of transactions in Canada, as in the U.S., has
been the relentless drive of financial buyers (as compared to strategic industry buyers who have
also been active, particularly in natural resources) in takeover activity. The record closings of
new vintage private equity buyout funds, coupled with dry powder from prior vintage buyouts,
has meant an insatiable demand in money terms on the buy side of the equation, coinciding with
continued strong fundamentals on the sell side.
However the equity component has only been the tip of the iceberg. Throwing additional
fuel on the fire has been the ability to leverage that equity with cheap, covenant-lite debt, adding
an unsustainable frothiness to M&A markets. It leads one to legitimately ask whether the drying
up of the CDO and CLO markets on the heels of the sub-prime debacle means that “the party is
over” or whether the drunken binge is merely taking a market-correction breather. After all,
many sage commentators have for some time been predicting that correction on the basis that
acquisition debt has been under-priced for the risk for far too long.
The Power of Original Thought™
Montréal
Ottawa
Kanata
Toronto
Hamilton
Waterloo Region
Calgary
Vancouver
Moscow
-2-
What is of more immediate concern than the duration of the debt-fuelled drought is the
immediate impact of the current loss of leverage on deal making.
Some preliminary
observations:
1.
The rapidity of the change from “hot, hot, hot” to “the big chill” in a matter of weeks has
left a number of multiple billion dollar deals in financing limbo. The inability of the
financing banks to parcel out and distribute buyout debt has meant that bridge
commitments have been availed. Even where unconditional financing commitments have
meant that banks have had to legally step up to the plate, some financial sponsors and
targets have consensually agreed to top up the equity component and reduce leverage
multiples, perhaps recognizing the fear that otherwise they may be killing the goose
which has been laying golden eggs for some time now.
2.
To continue the metaphor, dividend recaps are, at least for the foreseeable short term, a
dead duck. This loss of adrenalin kick to buyout performance returns may have a chilling
effect on new money coming into the space but the juggernaut of pension fund money
looking for risk-adjusted returns above public market investments may suggest this is a
temporary phenomenon, with a return to more traditional financing covenants and higher
margins self correcting the problem.
3.
It would appear that the anticipated take-over bid premium which has been building in
the North American public stock markets has, to some extent, been squeezed out in recent
weeks with market declines causing some havoc for hedge funds. Of course this has
meant an opportunity for private equity firms who have lost the performance enhancing
magic of leverage to counter, to some small extent, with an ability to buy more cheaply in
the first place.
4.
On the sell side, the glee which has accompanied the build up to ever higher EBITDA
multiples, may have crested. Even though target balance sheets remain healthy and
fundamentals remain strong, the disappearance of cheap and abundant debt will affect the
modelling of what is a reasonable multiple downward.
The Big Elephant in the Room
-3-
5.
Lesser leveraged deals in the mid-market will certainly be less affected and the ability of
strategic buyers to compete more effectively with the financial sponsor giants, in the
large deal segment, will likely increase.
It will be interesting over the course of the second half of 2007 to observe whether the
loss of leverage and consequent impact on deal making, particularly in the LBO driven market,
will be temporary or more longer term. Cash has been king in contested take-overs and take
privates for some time, but the changes in the source of that cash, namely cheap and abundant
debt, is likely more than short-lived, at least while investor confidence remains shaken even in
the face of continued strong fundamentals.
For further information, please contact:
Nicholas Dietrich
Gowling Lafleur Henderson LLP
Suite 1600, 1 First Canadian Place
100 King Street West
Toronto, Ontario M5X 1G5
T: (416) 369-7288
F: (416) 369-7250
Email: [email protected]
The Big Elephant in the Room