Private equity firms batten down the hatches

Canadian equities have proven no place to hide during the financial storm, and that applies to firms operating in private markets too: venture capital, mezzanine financing and leveraged buyouts.

And that storm whips up winds in all directions. Fundraising has dwindled as traditional private equity investors find themselves overextended. The general partnerships that invest the funds have to ration their cash, lest new rounds of financing diminish their equity stake. The firms they invest in face their own challenges, from whether they survive to how much their stake will be diluted.

The environment has changed radically, even since September 2008.

“The deal flow dynamic has remarkably changed within the past 18 months to the extent that deals, transactions, are not walking in the door,” said Eric Berke, managing partner at TorQuest Partners, a mezzanine firm.

“We’re now faced with an environment where we had to build internal capacity to handle all of the transactional opportunities that were confronting us,” he told a recent private equity symposium, sponsored by the Canadian Institute of Chartered Business Valuators, the Canadian Venture Capital Association, Financial Executives International-Canada and the Toronto CFA Society.

It’s a similar situation in venture capital. “We think great companies are great companies, in good and bad times,” says John Albright, founder and managing partner of JLA Ventures and the co-managing partner of the Blackberry Partners Fund. “In bad times, the valuation plays to our strength, and in good times we sometimes overpay.”

The difficulty is finding and hanging on to a “great company” until the market turns.

“We have a few transactions that we would like to sell at the multiple that we bought at. The reality is that that’s not going to happen soon,” says Berke. “So what do you do about that? Our strategy is that operating businesses is the key differentiating skill set. Understanding our operating businesses is something that we spend a lot of time on — that doesn’t necessarily mean that sitting in a tower on Bay Street, we can be presumed to know how to operate the businesses. But what it does mean is partnering with terrific management teams and taking that partnership quite seriously.”

Firms and investors are mostly conserving cash to wait out the downturn. And because institutional investors are likely over-allocated, fundraising has fallen by half. On the other hand, depressed valuations mean portfolio firms aren’t looking for money if they don’t need it.

“What’s happening mostly in the community right now is, if you’re a pre–fall 2008 investor, you’re trying to solve your problems with your existing group of investors, so you don’t want to reach out to an outsider if you don’t have to,” says Albright. “Most really great companies are avoiding raising outside capital unless they’re doing really, really well in a horrible climate, which there are companies doing that. They’re rare, but they are out there.”

Adds Berke,”I will say that what we’re finding is that a lot of firms, including our own, are taking very active and pre-emptive steps to prepare their balance sheets to weather the storm, either enough cash to weather the storm or renegotiate debt — attempt to renegotiate covenants — which is essentially a form of buying insurance from the banks.”

But the companies that aren’t great face a cull. The portfolio firm can be shut down — which Albright likens to a “bring out your dead” scenario. Or it can be restarted, at a 50% or 60% discount to what it was worth 12 months ago. Effectively, he says, that means “you can invest in late-stage companies” — the ones ready to go public — or be acquired by a strategic buyer “at start-up valuations.”

Pricing has come down considerably in mezzanine deals too, reflecting reduced valuations.

“In mid-2007, we were financing deals with senior debt funding levels of up to 3.75 times just the senior [debt],” explains Berke. “Today, that’s two times, maybe 2.5 times.” Moreover, rather than using a second lien structure on a company’s assets, mezzanine firms are returning to debt financing with a warrant component.

Still, despite the current environment, Albright, for one, remains optimistic: “We will certainly expect that, based on our entrance multiple today, seven years from now, we would get a multiple expansion. We’re seeing transactions right now, with companies that do have revenues, at two-times 12-month trailing revenue. I’m not beating a deal on it, but I certainly do have expectations five to 10 years out that we’ll be selling at two- to four-times forecasted revenue.”

And there are opportunities, adds Berke. “We’re certainly looking at a lot of situations that are starting to be distressed for whatever reason. Those situations are generally around companies that are in a market downturn; companies that are in a cyclical downturn are providing some opportunities. We’re also looking at companies with expiring or maturing debt facilities, and we are offering solutions to many of those companies, since the financing market has largely dried up.” Of course, there is a caveat for the company: “An equity solution to maturing debt that can’t be replaced is a very expensive solution, but in some cases it does present an opportunity for us.”

(03/23/09)