On November 10, 2011, the Philadelphia office of Drinker Biddle & Reath LLP hosted its 5th annual roundtable discussion entitled "The State of the Debt Markets in Private Equity Transactions – How to Leverage Returns for Your Investors." At the roundtable, representatives of private equity sponsors, senior lenders, mezzanine lenders and investment banks participated in a discussion with Drinker Biddle's private equity and corporate finance lawyers.

Anthony S. Clark, CFA, Chief Investment Officer of the Pennsylvania State Employee's Retirement System (PA SERS) gave introductory remarks, sharing the perspective of a large pension fund when viewing private equity investments. Established in 1923, PA SERS is one of the nation's oldest and largest statewide retirement plans for public employees, with assets of approximately $25 billion and approximately 227,000 members. Mr. Clark discussed some of the challenges facing large pension funds in this economic environment and the implications for private equity funds that serve as investments for those funds.

Following the introductory remarks, there was a discussion among the participants. The discussion focused on both the current climate for deals and expectations for the future. Below are some highlights of the discussion:

  • Many of the participants agreed that closing deals has been particularly challenging of late. Deal flow for the fourth quarter of 2011 appears to be down as compared with the fourth quarter of 2010. However, there has been an increase in strategic M&A relative to platform investors, bringing the split closer to 50/50. There is also a growing number of situations where strategics and sponsors are partnering.
  • The effects of the recent recession are still being felt, as buying and selling activities are sensitive to macroeconomic fluctuations in the United States and abroad. Buyers have been reluctant to deploy capital in times of market uncertainty, which has resulted in a stockpiling of cash. One participant noted that upwards of $1.8 trillion in cash was being held by corporate buyers for purposes of growth acquisitions. In addition, private equity funds have not been able to divest themselves of portfolio companies at a predictable rate for the past several years. This has resulted in a backlog of companies that need to come to market in order to realize exit opportunities for private equity owners. Therefore, participants were optimistic that deal flow will increase in the next 12 to 24 months as these exit opportunities materialize.
  • Participants agreed that quality companies still command seller-favorable multiples, but distressed or other troubled companies have a substantially more difficult time finding a buyer, despite vigorous selling efforts by targets and bankers.
  • An interesting observation that was shared by certain sponsors as well as by certain bankers was that private equity funds are turning down debt that is available to them to keep leverage at manageable levels. That said, buyers are finding it easier to finance larger deals, while lenders are less willing to commit to acquisitions of companies with less than $10 million of EBITDA.
  • Private equity funds are investing more equity to get deals done, and there is less of an emphasis on mezzanine financing, as buyers can close smaller deals with just senior debt. Participants also observed that some cash-rich buyers find it easier to fund the purchase price out of pocket at closing and obtain financing after closing.
  • In an attempt to get sellers comfortable that a deal will go through, private equity funds are doing more diligence before submitting a letter of intent and are submitting bids without financing contingencies. This has increased the initial costs for private equity funds, but can be a valuable component of the overall bid package; providing certainty to sellers can be the determining factor in winning the deal even if the dollar value of the bid is not the highest. Additionally, in order to increase certainty, more buyers are expecting lenders to accept the buyer's due diligence review or perform their own due diligence prior to signing the commitment letter in order to reduce the likelihood that the financing contingency becomes an issue. Private equity funds have begun to require "Sunguard" provisions in the lender's financing commitment documents, which generally obligate the lender to fund the deal if the acquisition conditions are satisfied. For smaller deals, private equity buyers can rely on non-binding letters of intent to move the financing risk to sellers.
  • As to the state of the leveraged loan market, participants agreed that the market remains challenging and unsettled, with flex provisions being used to syndicate many large deals.

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