The Sky Isn't Falling

July 31, 2007

Following O.J. Trial-like coverage of Blackstone’s IPO, the debate about private equity taxation and seemingly endless analysis of how rich and powerful the mega buyout firms are, perhaps it’s only natural to see people overreact to the recent hiccup in the credit markets. And it’s not just the average Joe who thinks this way. Last week, an insightful, Harvard-educated colleague of mine walked into my office to ask what I thought about the LBO party coming to a close.

Maybe the New York City humidity is getting to me, but I just don’t buy the Chicken Little argument—at least not yet. Yes, it’s true that some large buyouts are having problems selling high-yield bonds, and the investor appetite for junk debt has clearly fallen. It’s also true that the market for CDOs—collateralized debt obligations—has been hammered because of subprime mortgage-related losses. These are bad things.

But the saving grace that many seem to have forgotten is that private equity firms are still loaded with cash and, last time I checked, aren’t obligated to give it back when the market tanks. That means a down market does not necessarily yield a quiet M&A market. To the contrary, some buyers may actually increase their activity, fueled by lower multiples and the absence of strategic buyers who might have used inflated share prices to pay for acquisitions.

At this point, the skeptics are saying ‘That’s a great argument, Adam, but you’re forgetting about the debt. If lenders run for cover, where are financial sponsors going to get the financing?’

From lenders, of course. Sure, terms may get more restrictive, and interest rates may go up, but any established, well capitalized private equity firm with a well thought out acquisition is not going to come up empty.

Ultimately, it comes down to the pain you’re willing to endure—i.e., how much equity you’re willing to provide. If you’re plunking down 40% equity, instead of 25%, that would be pretty painful. But if you’re also paying a lower multiple, many private equity firms would still pull the trigger. (I haven’t done the math on this yet, but it’s a gut feeling. I’ll leave it to the quants to figure out exactly how those numbers correlate.)

In sum, I wouldn’t expect a major drop in M&A activity over the next six months. But deal execution will invariably become more painful.

Let me know what you think.