At the peak of the private equity boom, the largest leveraged buyouts ballooned in value and captured headlines. Traditional middle-market deals also grew at a robust pace, but with less fanfare. Now that the market has turned, both sectors are challenged.

Panelists at the 2009 Wharton Private Equity & Venture Capital Conference, “Multiplicity Without Rhythm: Investing in Chaotic Markets,” said opportunities, or “gems,” are nonetheless still available for investors in midsize deals if they approach transactions creatively and consider taking new and innovative positions in companies’ capital structures.

Private equity professionals discussed credit market conditions, deal flow and fund-raising in the middle market in a session titled, “Finding Gems Under Rocks: How to Drive Value Going Forward in Middle Markets.” The middle market was defined as private equity funds with capital commitments of $250 million to $5 billion and transactions with a total enterprise value of $100 million to $2 billion.

The discussion focused on constraints in the credit market and strategies to restructure financing and operations within portfolio companies to protect investments. Michael DeFlorio, senior managing director at Harvest Partners, began by characterizing the economy as not equal to the Great Depression, “but if there’s such a thing as a lower-case depression then we’re in one.” With the possibility of 10% unemployment and a dramatically changed banking environment, he said, companies need to avoid Chapter 11 bankruptcy because they may not find debtor-in-possession (DIP) financing to exit. “Traditional sources of DIP financing are husbanding capital and reserving it for companies they really want to be in, not DIP situations.”

According to Robert Long, managing director at Allied Capital, the sick economy’s underlying causes — similar to other recessionary cycles — boil down to a lack of confidence among consumers and investors who are readjusting to new realities following a bullish 25 years. “The unwinding of all that leverage has to take place, and we have the situation where you are constantly marking down the existing assets as waves of liquidation keep coming.”

When the liquidity pressure subsides, he said, markets will have created a bottom. Default rates will be a key indicator, though they tend to lag, not lead. He predicted default rates would rise to 10% or even higher in the next 12 months. “We are looking at liquidations subsiding this year, and when you see liquidations stop, that’s when new capital will come in in new forms.” Seller financing remains viable, he added, because sellers are happy to take some capital — instead of none — to get a deal done.

Bankruptcy’s Changing Face

In connection with default rates, said Jeff Feinberg, managing director at Alvarez & Marsal, the traditional Chapter 11 bankruptcy case has changed because of the lack of DIP financing. “Turnarounds in the court are done. It’s going to be out of court and it’s going to be expensive and it’s going to have to be funded by equity because the banks aren’t going to be there for you.” The fear is tremendous that if a company enters bankruptcy, it will wind up in liquidation because of difficulty in finding deal participants, he noted. “It’s shocking, but really telling as to the nature of what’s happening today.”

According to Feinberg, the new focus on out-of-court restructuring requires balancing severe cost cuts with the possibility that the cuts kill off the chance to “live another day.” He predicted that consumers will not provide a revenue runway for turnarounds, as they have after past downturns. “The pressure on the process is significant. Private equity shops can’t go to their lenders. They have to go back into their own pocket and double down. It’s a very difficult situation.”

Reginald L. Jones III, managing partner at Greenbriar Equity Group, noted that while the federal government has provided about $2 trillion to financial markets, including through its Troubled Asset Relief Program (TARP), attempts to revive the economy through such credit injections had not yet paid off as today’s tight market conditions continue. “My suspicion is that the TARP has been given out in large chunks to institutions that will use it to replenish their balance sheets. I would say I haven’t seen any evidence that TARP is having a positive impact.”

Jones cited a Boston Consulting Group study that forecast that 20% to 40% of private equity firms would go out of business because of the economic crisis. As a result of falling asset prices elsewhere in the financial system, many limited partners are now overexposed to private equity, he said. They will want to reduce their commitment to the sector to bring wounded portfolios into better balance. “I do believe there will be a shakeout in the sector.”

Three Forces Shaping Markets

Peggy Koenig, managing partner at Abry Partners, pointed to three aspects of the credit environment that will shape private equity investment. First is that hedge funds’ forced selling will continue to erode markets. Second, lenders haven’t recognized the true value of the debt on their balance sheets, with many still valuing impaired credit at par. Third, lenders and troubled portfolio companies haven’t begun to work out their problems. “Everyone is pessimistic and will continue to be in 2009 and 2010 as all this continues to unfold.”

G. Daniel O’Donnell, chair of the Private Equity Group at the global law firm Dechert LLP and the panel’s moderator, said that as credit markets began to fall apart in 2007, analysts predicted that mega-deals would dry up, but that mezzanine funds and other third-party lenders would step in, allowing mid-market transactions to continue. Data from 2008 indicates that didn’t happen. O’Donnell asked why.

When the correction began in August 2007, Koenig explained, private equity players were offered several opportunities from institutions unable to syndicate their transactions. The companies weren’t really attractive, she said, and the pricing wasn’t good enough to motivate mezzanine funds. That is changing, she added, and the debt backlog is being whittled down. “Now what we’re seeing is a lot more attractive companies coming into the market, and we are able to receive very attractive pricing.” In addition to good prices, she said, Abry Partners is able to move up in the capital structure while still targeting returns of 20%.

O’Donnell also asked whether a trend among private equity firms to buy more debt in companies in which they already have a position is a fix to the problem, or just a fad. DeFlorio said he thinks the strategy is a fad that seems attractive because senior debt is trading at 60 to 80 cents on the dollar. Firms might be willing to buy additional debt because they feel a company remains a good investment, he added, but doing so amounts to doubling down on a bet. “If your equity is underwater and you are now buying debt, you don’t want to be wrong twice.”

O’Donnell further asked about attitudes among limited partners toward changing the traditional structuring of middle-market deals. “Do you worry about limited partners accusing you of, in effect, creating strategy drift?” he asked.

According to DeFlorio, the existing opportunities lie in distressed companies’ senior debt. If a firm holds onto the notion that the role of middle-market private equity is to come in at the bottom of the capital structure, “You’re not going to be very busy. Or,” he continued, “middle-market firms can choose to find attractive risk-return opportunities and play different parts of the capital structure in a creative way to put money to work.”

What Style Drift?

DeFlorio stated that his firm had talked to limited partners and that no clear consensus had emerged on whether they are concerned about style drift in taking on debt. They have made it clear, however, that they want the firm to “stick to its knitting” in the types of businesses it invests in.

On one hand, Jones said, limited partners pay the firm to manage money because they believe it is smart and capable and, if it makes a mistake, it will be fired. However, he said, market conditions transcend concerns about style drift. Many limited partners have experienced massive declines in their portfolios’ public-equity portions and are now overweight in private equity. To make a cash call to seize on a chance to buy a great company at a good price, limited partners would have to sell equities in companies at distressed prices.

“There’s a question around the value proposition we offer to limited partners,” he conceded. He said private equity firms are on the spot because if they don’t invest in anything, two years from now their limited partners will wonder why they are paying the firm to do nothing. “If you want to be a true partner,” Jones said, private equity firms need to provide limited partners with transparency and detailed explanations.

O’Donnell asked about the impact of so-called covenant light financing, or loans without traditional levers, such as working capital requirements, that can signal danger before a company slips into deep trouble. This type of financing was popular during the private equity boom years, and O’Donnell wondered whether it would delay the downturn’s effects because lenders may have no indication that they should be working with a troubled borrower until it is in full default.

Feinberg agreed that a lack of covenants may make problem private equity deals worse in the long run. “We’re all paying the price now.”

The business model of large leveraged buyout funds, which was to buy companies and then leverage the deal eight to one, is dead, Long stated. Middle-market funds have been less reliant on financial engineering than large LBO funds and are better prepared to create value in portfolio companies through operations. Middle-market private equity owners, he added, are better positioned than mega-funds to take a central role in the future “trajectory” of the companies they hold.