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Some buyers have even returned their recent purchases to the public market because of the credit crunch. In order to look at the year ahead, one must look back, from a few to several years. "Covenant-lite is down. Pik features are gone. It's a banker-friendly, covenant-heavy lending regime," said Charles Nathan, partner at Latham & Watkins.
The M&A market tends to run in cycles, and the coming year will be a low point for private equity. The year to July was the high point. Private equity almost tripled its value in deals during that period.
As the credit crunch continues through next year, the presence of private equity in M&A deals will be lower. Also, the size and volume of deals can be expected to be a rather small fraction of years past.
So, what will replace these huge going-private deals? The answers are varied. Some think strategic acquisitions will play a big part, on banker-friendly terms. "It's not that strategics will take over, but they will be more successful at competing with private equity," said Mark Gerstein, partner at Latham. In addition, the middle market should continue to stay active, possibly with some private equity involvement as its leverage reduces.
Others think private equity will be hovering above troubled companies, ready to strike. Distressed M&A may be a popular way back in for the investment houses, a good example being the $7.5 billion Abu Dhabi Investment Authority gave Citigroup this November. Vulture investing was also seen in deals such as Citadel Investment Group's $2.55 billion cash injection to E-Trade Financial, and should follow on through the new year.
Since the dollar is weak, some expect an increase in foreign investments into the US. Markets such as China, India, Thailand, and the Middle East are looking to be the front runners in this influx of money from sovereign funds, like the Abu Dhabi Investment Authority's stake in Citigroup. It seems likely that the increase in cross-border deals will be prominent.
These funds are filling a gap left by American banks, who don't look like they'll do much lending for a while. Sellers, equally, need to be realistic about what their assets are worth. The recent backout by Cerberus from its buyout of United Rentals is proof that matters need to be looked at differently than they were a few months ago. Deals are being negotiated harder than before, and that should continue into 2008.
The change in lending contracts is one of attitude, rather than situation. The reinstatement of proper financial covenants is due to a practical shift in perspective, according to some. "It's not scientific; it's what you can get," says a partner at a New York law firm. "I don't think it's the result of economic analysis. It's more attitudinal."
One answer is to "stop thinking about what's been and look at the purpose of letters and get back to those. It's to take the market risk out of the equation, and not the borrower risk," said one corporate partner.
Although deals are being negotiated harder, some consider that the banks are trying to push responsibility onto their lawyers. "A developing trend is that banks are beginning tolook to outside counsel more to protect them as institutions. Managing risk is a more institutional point of view," says one partner.
As strategic acquisitions may be making a come back next year, some are considering using stock, rather than relying on cash. Capital may be available but it will be at lower leveraged ratios.
In addition to complex strategic transactions, investments in infrastructure should pick up. The deals aren't as blockbuster as some of the private equity deals in the past year, but they do have positive cash flows. Infrastructure, such as roads, is structured more like project finance. This remains attractive to lenders because of the certainty of returns – people are not going to stop driving, despite the rising oil prices.
"There is an attractiveness of long-lived assets and steady recession-proof cash flows. Returns aren't dramatic but there are good returns and opportunity for profit," says Nathan.
The situation looks hopeful, but it is still up in the air. "It's a bit of wait and see. Much depends on the looming cloud of recession, which will either darken or dissipate," says Mark Greene, partner at Cravath Swaine & Moore. LB