While deal sizes may have shrunk because of the credit crisis, there is little evidence of a major downturn in buyout activity, writes David White.

One of the fears of the private equity market following the credit crunch that began in September was that the reluctance of banks to lend would put the brake on leveraged buyouts.

Yet the buyout market is not one but several market segments - mega, large, mid and small - and not all segments are likely to be equally affected. Indeed, some segments can survive the credit drought better than others, and some may even benefit form it

Tycho Sneyers, a partner at LGT Capital Partners, a Swiss-based institutional alternative asset and fund of funds manager which has just closed its latest private equity fund of funds focusing on small European buyouts, says the credit crunch has not inhibited deal activity in the middle market, in contrast to what has happened in the larger or mega buyout market:

"The average deal size has gone down. In the last four quarters, the average deal size was €900m whereas it has gone down to €400m in the third quarter of 2007. So the middle market has kept on doing deals, but the deals above €1bn have almost vanished."

Sneyers says the credit crisis has prompted a move back to the basics of private equity: "The historical meaning of private equity is very much smaller deals. Some 90% of private equity transactions take place with enterprise values of less than €250m. This is the thriving heart of the private equity world.

"The last three years have been a perfect storm in a positive sense for private equity where abundant availability and low costs of debt have led to a very low weighted average cost of capital for private equity firms.

"This has allowed private equity firms to acquire much large companies at higher prices without necessarily reducing the return on equity, because the cost of debt has come down so much and the proportion of debt has increased.

"Now we are in a different cycle where the cost of debt is going up and the proportion of debt in a private equity transaction is going down; this is going back to a more normalised environment." While credit for the mega deals has dried, up there is no such problem for the small and middle market buyouts, Sneyers says. "For the multi billion deals requiring multi billion debt packages banks typically need to syndicate, and that is where issues have risen following the credit crisis. So that segment is not liquid any more.

"But for the smaller deals, banks can put together a smaller debt package at three to four times EBITDA (earnings before interest depreciation and amortisation), which is not stretching the balance sheet of smaller companies. These debt packages are not suffering from the debt crisis. They are even becoming more prominent as banks are moving away from the very large deals, with debt at seven to nine times EBITDA." Certain firms can not only survive but prosper in this environment, Sneyers says. "If default rates increase this represents an opportunity for equity firms in the turnaround space and distressed field where there has been a very limited number of opportunities in the past three or four years."

LGT Capital Partners has adjusted its portfolio accordingly, he says. "From a tactical perspective we are overweighting the distressed and turnaround specialist because we believe they will have very good deal flows, in the year to come.

Smaller and middle market buyouts firms also stand to gain if sellers reduce their prices to more realistic levels, he adds.

"In the last three or four years we have seen average quality companies being sold at top quality prices.

"We could see that now shifting to a scenario where sellers reduce expectations in terms of the multiples they can get for this business and that would be a very good opportunity for smaller an mid market buyout firms in Europe."

In the UK, firms in the traditional buyout space of deals between £20m and £100m have also been less vulnerable to the credit crisis.


Philip Buscombe, chief executive of Lyceum Capital, a UK-based private equity house at the lower mid market area, says the firm has experienced few difficulties finding bank finance.

"Post 1 September we got proposals with sellers that have been financed by banks. Generally all of these are financed on exactly the same basis as they have been over the past two to three years, with the same amount of debt, the same amount of enthusiasm and a very similar approach.

Some banks are now readier to lend than others, he says. "We discern some differences between banks in terms of appetite, but that is normal."

Banks are also looking for a higher margin, typically 25bps. But Buscombe says this has to be seen in the context of decreasing margins over the past three years. "It brings the position back to where it was two years ago, and certainly not where it was five years ago."

Lyceum Capital relies for finance on a panel of ‘relationship banks' "These are banks that we have known in many cases for 20 years," Buscombe says. "Typically it's a non syndicated market, and because it's not a syndicated market we know where the debt is."

A 25-year track record in the traditional buyout market helps, Buscombe says.

"We have a very strong relationship with banks because we've been in the business through different cycles. Our senior people here were doing this between 1989 and 1993 the last time we had some problems. That plays very well with these relationship banks because they've had experience of us when we've had some companies that have done less well."

In general, buyout firms operating at the smaller end of the market will be less vulnerable to a credit squeeze than their larger colleagues because they use less leveraging. Lyceum Capital goes no higher than 50% leverage of the capital structure.

"If a typical public company uses three times EBITDA we typically are putting four or four and half times EBITDA in a transaction," Buscombe says. "So it's not highly leveraged, and is usually about half the purchase price.

The greater the importance of credit in a transaction, the more susceptible it will be to changes in the availability of credit. "In other parts of the buyout market, the pricing and the structure of the deals is credit-driven.

"This means that, over a 10 year period, there will be three or four years where the debt multiples get pushed up by more credit becoming available. That's obviously been a very significant feature of the larger buyout market in the last few years.

"But in our market, if you look at the peak and the trough in the cycle in terms of debt availability, you will find that the amount of debt varies very little for a reasonably good company. Between the more constrained debt periods of the cycle and the more gung-ho parts of the cycle, it might be no more than half a point of EBITDA.

"The whole behaviour in our part of the market is not debt related. We are not unduly reliant on repaying debt for most of the financial returns that we make."

Middle and small market buyout firms may be better able to cope with a credit crisis than the mega market firms. But whether they benefit from the crisis is an open question. Thomas Kubr, chief executive of Capital Dynamics, a Swiss-based asset management firm that targets most of its investment at buyout companies, is doubtful.

"It is probably sensible to assume to make that the mid and small end of the buyout market may be less affected than the large end, but one should not make the mistake of saying that a particular size of buyout firm benefits from that.

"It's not a zero sum game we are dealing with here. Every segment of private equity has lots of room to grow, and because one grows less than another doesn't mean that the one that grows more is winning.

Kubr believes that the crisis has been over-stated and that debt is available, even to the large buyout firms.

"The direst predictions are not really coming through. The debt is being moved, the big deals that have been put together seem to be going through."

The main effect of the crisis will be that debt multiples will return to reasonable levels, he suggests. "By the end of the year we will not be back to where we were in the spring of this year but we will be back to normal - normal being debt terms back where they are at the long term average," he predicts.