As a potential seller seeking a liquidity event, will the current credit markets prevent me from finding a buyer/investor at an acceptable valuation multiple? Are potential buyers/investors unwilling to pursue transactions in the present financing and economic environment?
These are common questions our clients have asked over the past several months. As we've predicted, 2008 has become a year of reduced activity and valuations in the M&A marketplace. Franchised and independent concepts are no exception, and have also become victims of deteriorating macro-economic and financing trends. Transaction counts and new unit development activity are down substantially from prior years, not to mention the significant lag in existing development schedules.
Many "would-be" acquirers are sitting on the sidelines waiting for the economic news and capital availability to improve before pursuing acquisition and growth transactions. Others, however, are still interested in pursuing their long-term investment strategies.
Given today's current tight credit markets, how are those still seeking growth finding the capital necessary to fund their expansion? Historically, tight credit markets provide advantages for, and greater activity from, strategic companies whose objective is to "stay the course" consistent with their long-term development plans. Strategic buyers typically have stronger balance sheets and are not as dependent on financial engineering to make transactions economically feasible.
Investors and acquirers who are more financially oriented are more likely to wait for market conditions and capital markets to improve before becoming more aggressive in executing their acquisition and expansion strategies.
Financial investors with a more strategic focus (i.e., those with current industry investments) tend to behave more like strategic companies and seek to take advantage of their capital resources and less-competitive acquisition and investing conditions. In our opinion, these firms are less focused on an acquisition meeting short-term return criteria and tend to view acquisitions as part of a longer-term investment strategy.
Creativity and perseverance are the keys to getting transactions done during these times. What follows are four successful strategies employed by firms that have historically thrived in uncertain capital market conditions.
Debt capital is still available. However, lenders have become more limited in their focus and more conservative in their overall approach to underwriting. Transactions that are not "mainstream" (e.g., requiring higher leverage, suffering from performance issues, or lacking significant concept stability and/or validation) have been affected most significantly. Concepts withstanding the current economic slowdown by sustaining positive or stable comparable sales with strong balance sheets continue to be able to secure debt for transactions. Lenders are still in business and need to fund transactions, although at more conservative advance levels and less attractive terms and pricing.
With more conservative advance rates and higher spreads, sophisticated borrowers are employing debt capital with more of a short-term view relative to their overall capitalization structure. As such, we are seeing more variable-rate financing and a general unwillingness from borrowers to lock into long-term fixed-rate financing, while employing higher equity levels to complete deals. This eliminates or reduces the risk associated with prepayment penalties when a refinancing might be on the horizon when lending conditions improve.
Additionally, many strategic acquirers, as well as strategic private equity firms, are using embedded equity from their existing balance sheets to facilitate required debt financing for transactions and growth capital. Cross-collateralization strategies using unencumbered assets as well as complete company-wide recapitalizations (operations and real estate or other assets) are tools being used by savvy borrowers to accomplish their debt financing needs.
Mezzanine financing is on the rise, supplementing more conservative levels of senior debt financing. Historically, when senior debt financing terms and pricing are aggressive, the mezzanine market experiences a reduction in demand as advance rates for senior debt become more aggressive, leaving a smaller gap for traditional mezzanine financing to fulfill. Tight senior debt markets create a wider gap in the capitalization between debt and equity capital, facilitating greater demand for mezzanine capital. Relative to its more expensive equity counterpart, many borrowers find mezzanine financing to be a useful option under current market conditions. Additionally, mezzanine providers have become more flexible with the terms and structures they are willing to accept. Creative structures using varying cash and non-cash interest rates and equity ownership have become more commonplace with mezzanine sources.
We also continue to see interesting developments with the equity capital markets. Many private equity acquirers and strategic buyers with strong balance sheets have elected to forgo the use of debt capital in the existing financial atmosphere. Most of these acquirers will pursue a very limited number of transactions and focus only on those with the highest priority. As a result, the demands on their equity capital can be far less than in other, more active periods. Given the lack of attractive debt financing coupled with a substantial amount of idle equity capital resources, many of these firms will elect to put a higher percentage of equity to work in a limited number of transactions and in some cases eliminate all debt financing. The strategy is to invest idle equity capital now with the intent of recapitalizing the company when the market normalizes.
Additionally, we are seeing many private equity firms with substantial unutilized resources willing to entertain more creative non-typical uses for their funds. To generate some return on their idle funds, some have been willing to invest short-term proceeds with terms and structures more attractive to borrowers than typical long-term equity solutions. Where they might be unwilling to take a lead role in the acquisition of companies, many of these equity sources are keen to put their capital to work and are entertaining creative applications alongside strategic buyers.
Seller financing is not what it used to be. Historically, seller financing was a means of achieving a seller's purchase price objectives when the underlying debt markets would not support the buyer's required level of debt. Most of this debt was typically structured as some form of subordinated second lien debt, paying a coupon only slightly higher than senior debt. Today we are seeing more creative forms of seller-funded capital including mezzanine structures, equity participations structures, and other structures designed to facilitate early redemptions. Depending on the situation, many sellers are willing to accept higher levels of risk in "keeping a piece of the pie" in order to participate in a future liquidity event. These structures require a high level of comfort between buyer and seller, cooperation, and long-term confidence in the business. These structures can also bridge the valuation expectations between buyers and sellers in tight financing environments. In the current environment, these creative structures can mean the difference between closing a transaction and being forced to wait for the capital markets to improve. In many instances, this contributes to higher overall returns to the seller, along with higher levels of buyer confidence.
While many pundits have declared the mergers and acquisition marketplace on life support in the current financing environment, we continue to experience positive activity when both buyer and seller are motivated and creative in finding solutions to the current pullback in capital availability. Deals are being completed. The key to success is the ability to be patient, creative, and flexible.
Dean Zuccarello, CEO and founder of The Cypress Group, has more than 25 years of financial and transactional experience in mergers, acquisitions, divestitures, strategic planning, and financing in the restaurant industry. The Cypress Group is a privately owned investment bank/advisory services firm focused exclusively on the multi-unit and franchise industry for more than 17 years. Contact him at (303) 680-4141 or at firstname.lastname@example.org.
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