It may not be the 1980s again, but there are signs that the leveraged buyout is back.
True, the multibillion-dollar deals of the 1980s are not in the works, but the LBO action for middle-market companies deal sizes in the $100 million to $1 billion range is heating up in Los Angeles.
There are a variety of reasons why the big deals still aren’t being done through LBOs, mostly connected to junk bonds. The nation’s high-yield bond mutual funds are losing deposits and that means they are net sellers, not buyers, of junk bonds, which are issued to finance the really big buyouts, explained Ron Spogli of LBO shop Freeman Spogli & Co. in West Los Angeles.
“It is very difficult, maybe impossible, to get a big deal financed,” he said. “The bond buyers aren’t there.”
In addition, large-cap companies trade for handsome multiples on Wall Street today meaning they are not cheap, and thus generally not obtainable by investors armed with loans. As seen so much in the late 1990s, the stock-swap merger is how the really big corporate deals are being done.
Action in the middle
But for middle-market deals, LBO activity is intensifying for two reasons, say financiers: first, the money can be found for a middle-market buyout, and second, many middle-market enterprises, especially Old Economy companies in non-tech services, are selling for single-digit multiples.
For example, Los Angeles-based homebuilder Kaufman & Broad Home Corp. is selling for five times earnings; Torrance-based furniture maker Virco Manufacturing Corp. trades at eight times earnings; Pomona-based Keystone Automotive Industries Inc. trades at 10 times earnings; and Pasadena-based cement pipe and engineering company Ameron International Corp. trades at seven times earnings.
Meanwhile, the overall S & P; 500 index, a broad index of blue chips, trades at 30 times earnings.
There is ample, although expensive, “mezzanine” financing available for middle-market LBOs, say market players such as Warren Woo, head of leveraged finance for Donaldson Lufkin & Jenrette Securities Corp. in Century City.
“We (DLJ) have a $2 billion mezzanine fund, Goldman Sachs has a mezzanine fund, Apollo (buyout shop in Beverly Hills) runs its Aries Fund, and TCW (money manager in downtown Los Angeles) runs a mezzanine fund the money is there,” Woo said.
Mezzanine financing is the money used to fill the gap between the full amount a borrower needs and the amount he is able to secure through traditional loans and equity investments. Unlike a commercial loan, which is typically secured by the borrower’s assets, mezzanine loans are usually made on the basis of the borrower’s cash flow and the perceived value of his company.
And these mezzanine funds are increasingly being used to buy up the undervalued shares of public companies, and take the companies private.
Recently, Westside buyout shop Leonard Green & Partners announced a deal to “take private” Los Angeles-based Veterinary Centers of America Inc., a publicly traded chain of vet shops.
Green agreed to buy VCA for $15 a share, or about 12 times earnings. It financed the buyout with a mixture of its own capital, bank loans (the portion secured by assets) and mezzanine financing, the latter provided by New York-based brokerage Goldman, Sachs & Co.
In other words, no bonds were floated, no registrations were made with the SEC. Commercial bankers and mezzanine fund managers financed the deal, not investment bankers. With junk bonds out of favor, and commercial bankers only willing to lend on secured assets, the mezzanine financing becomes critical.
“We have probably borrowed $500 million in the mezzanine market in the last year, and just $30 million in the five years before that,” said Peter Nolan, principal with Leonard Green. “That will tell you how much the markets have changed.”
Expensive money
But mezzanine debt is “not cheap,” says Nolan. Indeed, mezzanine lenders generally want returns of between 18 percent and 22 percent annually, in interest and equity kickers, in an era of low inflation and interest rates.
And before they lend, they want to see that the people behind the LBO are putting in lots of their own equity first. In other words, mezzanine lenders won’t shell out for an over-leveraged deal.
In the last 60 days, as investors have become a little troubled by the economy and the possibility of higher interest rates, the mezzanine lenders have been asking for even higher returns, said Ed Bagdasarian, managing director with Barrington Associates in West Los Angeles, a very active merger shop.
“If they wanted an 18 to 20 percent return two months ago, now they want 20 to 22 percent,” he said, referring to total return including interest and warrants. Such expensive money means that usually only companies with lower price-earnings ratios can be bought, said Nolan.
“It is hard to buy a company at 20 times earnings on money you borrowed at 22 percent,” he said. “Of course, that doesn’t mean that just because a company is cheap we will buy. But it can’t be too expensive, either.”
A few big leveraged buyouts have gone through this year, but only when all aspects were blue-chip, such as the March LBO of Scotts Valley, Calif.-based Seagate Technology’s disk-drive operations for $2 billion, the largest tech LBO of all time. The buyout shop was Silver Lake Partners, based in the Silicon Valley.
