Deal market remains cool

Despite the billions of dollars that have been pumped into banks by the U.S. Treasury Department’s Troubled Asset Relief Program (TARP) and related programs, merger and acquisition-related lending in Milwaukee and around the country is difficult to obtain, many of those within the deal community say.

“The TARP money has mostly been used to shore up balance sheets. The lending markets have not improved. Credit standards have not loosened,” said Ronald Miller, managing director with Cleary Gull Inc., a Milwaukee-based investment banking and wealth management firm.

“I’m working on a $100 million deal right now, and (banks) are not buying debt. They’re only interested in it unless they lead the deal. Banks are de-leveraging now, they’re not buying credit.”

The lending market is tough right now because bankers are closely scrutinizing both cash flow and assets when they’re examining M&A deals, said Linda Mertz, managing director of Waukesha-based Mertz Associates Inc.

“In general, business’ cash flow is down and their asset value is down because the used equipment market is in the tank,” Mertz said. “Plus, they don’t know what their projections are going to be like, that’s the biggest thing.”

Banks that are willing to lend for M&A deals are only looking at asset value, not cash flow, said Victoria Fox, managing director with Milwaukee-based Emory & Co. Previously, banks would include an extra portion of financing that would account for cash flow, whether it was explicitly stated or not.

“We used to get what we’d call an air ball, and that’s what has disappeared,” Fox said. “The air ball was the portion of the loan that was not covered by collateral. The banks used to reach beyond (the business’) asset base. That’s not happening now.”

The difficulty in obtaining bank financing has resulted in buyers – both private equity and strategic – putting more equity into deals. On average both private equity and strategic buyers are now required to put about 50 percent of their own cash into buyouts, Miller said.

“It’s basically changing the structure of deals,” Fox said. “On (one) particular deal we are working on now, our sellers are taking a seller note. It would have been an all cash deal in the past. This is making a larger portion of the price in deferred payments… either a seller note or earn-out or the sellers are keeping more stock in the company.”

Banks are even less likely to lend to new customers, Miller, Fox and Mertz said, and are focusing on existing clients now.

“Loan officers are spending less than 10 percent of their time on new loans,” Mertz said. “They’re relationship officers and they’re trying to figure out what problems they may have.”

Many banks have also centralized loan-making decisions, which in many cases has limited or removed local input and decision making.

“The banks don’t know which companies are going to succeed or not,” Mertz said. “They’re preserving their balance sheet. They want to look good in a stress test and they want to survive.”

Over the last year, banks have been discouraged to lend money, especially those under TARP or other federal “bailout” programs, said John Beagle, managing director with the Milwaukee-based investment banking form Grace Matthews Inc.

“For the last 12 months, the banks have been graded on their balance sheets, not income statements,” he said. “We have been expecting them to be solid, liquid and an ongoing concern. There has been a disincentive for banks to make loans for the last 12 months. Until the rules became clear, that’s stayed in place.”

While acknowledging that banks have slowed their lending volumes, Peter Thursby, executive vice president in corporate banking in the fee income group at Green Bay-based Associated Banc-Corp., said lenders are not the only parties to blame for the slowdown in M&A volume.

“The economic downturn has obviously created challenges throughout the banking industry, he said. “The contraction that has occurred in the M&A market is largely due to the significant disparity between buyers’ and sellers’ expectations, particularly in the middle market. Banks still look at the merits of transactions individually, particularly in these economic times.”

Some light in the tunnel

However, the rules have come into clarity over the first half of 2009, Beagle said.

“The TARP rules are now more clearly understood and enforced. You can tell by (many) bank stock valuations, and investors are back to help banks make loans and make money,” he said. “For six months, lenders just wanted to have lunch. Now they want to have lunch and actually have some money to lend. It’s getting incrementally better, trending towards a more friendly lending environment. The lending windows are open, just not wide open.”

“The volatility in the market is down and visibility is better. Companies are adjusting to the new reality,” Miller said. “We kind of know where we are and the reduction in volatility is increasing the quantity of conversations we’re having.”

One of Emory & Co.’s clients located on the East Coast was unable to find financing in their market, but has had better success in the Milwaukee area, Fox said.

“The Milwaukee banking market has fared better than other parts of the country,” she said. “No one (on the East Coast) was even willing to look at senior debt. We brought our clients here and they met three banks that said they had an interest in financing, but the levels we’re looking at are lower than they would have been even a year ago by less than half.”

Financing is available for high-quality M&A deals, where both the buyer and seller have highly visible markets with easily predictable order projections, Miller said.

“The banks are not closed (altogether) but the underwriting standards are pretty tight,” he said. “If you get out of bounds and once you start to need some creativity, it’s very difficult to get a traditional lender to underwrite something with difficult credit.”

Limits and opportunities

The tight lending markets are limiting the ability of many private equity firms to make acquisitions because of their general practice of borrowing to make purchases. Many strategic buyers are being careful about acquisitions, because many banks want to renegotiate credit rates for whole relationships in exchange for new commercial loans.

“From a strategic standpoint, if a company has an available line, they’re able to do acquisitions,” Fox said. “But some of them are sitting on the sideline because they don’t want to give up the good terms they have.”

Beagle said Grace Matthews is putting strategic buyers into the “haves and have-nots” categories now.

“Some strategic buyers with healthy operating cash flow and debt that is not due for four years are in a great position,” he said. “The others with debt that is due in the short term are in trouble. The banks are unhappy with pricing on existing loans and they’re taking every opportunity to renegotiate existing debt packages.”

Some buyers are using the market conditions to their favor. Strategic buyers that have enough cash to make acquisitions without any bank debt are doing so. And some private equity groups that operate without raised funds are as well, including Milwaukee’s Lubar & Co.

“It’s been a huge advantage for us – we’re traveling to Detroit to meet with a possible acquisition,” said Dave Bauer, chief financial officer at the firm. “When we come to them we can say we’re using our own capital, the decision makers are at the table and we traditionally have not used a lot of bank leverage in transactions. We just keep functioning like we have done in the past.”

Slow recovery ahead

While large market deals of more than $250 million have picked up some traction in recent weeks, the small to middle market will take longer to recover, Miller said.

“We entered this a little late and we’ll leave it a little late,” he said. “It will be well into 2010 before middle market deal volume increases.”

Mertz agreed, but said alternative lending markets such as hedge funds and some private equity groups themselves will come down in price, making non-bank debt more palatable.

“Capitalism survives – we’ve gone through a dramatic shift that has caused people to be very conservative, and that’s not going to change any time soon,” she said. “But this shift creates opportunities for those that are very smart and know how to underwrite different situations. People will figure out how to serve the market. Some of it (alternative financing) is very expensive now, and there are inefficiencies.” 

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