How long corporate buyers will continue to hold their advantage depends on the answer to a crucial question facing private equity deal makers: Why are banks so unwilling to lend money to finance highly leveraged private equity buyouts? After all, they too need to keep making money, and until recently, these loans, often made at very high interest rates, were quite lucrative. Jonathan Lynch, a managing director at private equity firm CCMP Capital Advisors LLC, defines the problem succinctly: “The problem is that banks can’t risk losing money either. They have to balance their capital reserve requirements against their risky assets, and no one wants to make a mistake right now. As liquidity disappeared, so did the willingness to take risks.”
It may take some time for that willingness to return. First, in the near term, market participants need to decide that the chances of another major investment failure have been significantly reduced; at the moment, many believe another one is yet to come. That depends, in turn, on the state of the housing market when all the ill effects of the mortgage crisis become known. Second, the consequences of the loose lending standards of the past few exuberant years in the private equity market need to play out. Will many of the highly leveraged companies in private equity portfolios fail if the economy stays sluggish? Or were the terms of many of these loans — the so-called covenant lite deals — so easy that it’s almost impossible to default on them?
Even in the longer term, investors will need to decide just how much risk they’re willing to take on. Wall Street is notorious for having a very short memory, and if the past is prologue, it may be all too happy to return to the high-risk times of two years ago, to the tech bubble of the late 1990s, or to the savings and loan crisis of the early 1990s. But if investors have learned one lesson from the current liquidity crisis, it’s that they need to understand the nature of the risks they are taking. “Two years ago, people pooh-poohed risk,” says Gus Faucher, director of macroeconomics at Moody’s Economy.com. “In retrospect, there was all this risk out there that people didn’t recognize. Now they’ve probably overshot in the other direction. There’s an equilibrium out there, but we haven’t reached it yet.”
Until we do, corporate deal makers can take advantage of the current environment of generally lower valuations and less competition by looking for companies that fit nicely into their businesses. These might simply be so-called bolt-ons, which can augment the purchaser’s strength in a particular product area or market. Or they might be more growth-oriented acquisitions that can lead the acquirer into a new product area or market. Either way, it’s a good time to make hay while the sun shines.
Edward H. Baker, former editor of CIO Insight magazine, is a contributing editor at strategy+business.