BusinessTN

Private equity buyouts of publicly traded companies were all the rage this year—until troubles with subprime mortgage lenders sent shockwaves through credit markets worldwide, catching even the Federal Reserve offguard. The Reserve first said the economy was in good shape but changed its mind by late August, at first cutting the discount rate it charges banks on short-term loans. As some deals were falling apart, BusinessTN polled four mergers-and-acquisitions attorneys to see how the industry is coping and what might happen next.

Roundtable Participants
• Stuart Campbell: Stites & Harbison
• Robert Harris: Waller Lansden Dortch & Davis
• Douglas Quay: Glankler Brown
• John Titus: Boult, Cummings, Conners & Berry

BTN—We’ve watched Jim Cramer melt down on television, screaming at the host that the Fed is complacent and financial Armageddon is upon us. What is going on?

Robert Harris—You’re seeing a chill in the subprime market, which has spread to other instruments, such as collateralized loan obligations. The loss of confidence in some parts of the market is causing people to retrench on the terms of their lending. For awhile, we’ve seen very favorable financing terms with covenant-lite deals and very low pricing. Now people are realizing that pricing was too favorable due to great amounts of liquidity from private equity funds, and people are pulling back, starting to adjust their pricing to a more traditional model. The markets are moving back to where they have been.

John Titus—That’s right, and the recent comments from Chairman Bernanke support that. Some of the recent deals with private equity may hurt the market. Instead of the private equity funds having direct relationships with the banks, more and more of the debt pieces of each transaction are getting split up. Hedge funds are taking parts of the deal. It’s getting harder for the market to figure out who’s actually holding the paper on all those deals. That’s adding to the uncertainty. If all the debt is being held by a few major banks, the markets have a better feel for how the banks will react if there are problems with the credit facility. But if portions of that debt have been parceled out, there’s more uncertainty as to what will happen as those highly leveraged companies run into problems.

Douglas Quay—I was reading comments from the CEO of IndyMac Bancorp who said it’s difficult, if not impossible, to trade even the AAA bonds on private mortgage-backed securities transactions. I’ve never seen that happen. This is definitely spreading to other areas. A triple-A mortgage-backed security is not a subprime instrument.

Stuart Campbell—Doug is right. Much of this started in the subprime market, and many people are uncertain as to how deeply it’s going to expand. With that kind of uncertainty, people either have more stringent requirements on their deals or they just hold out for a while to see what the competition and the market is going to do.

Harris—Also, investors are becoming more and more reliant on rating agencies to rate the paper. With banks not doing as much lending, many loans are being parceled out to different investors and chopped up, and tranches are being sold so that those investors are relying on the rating agencies. I was reading in the New York Times’ Sunday business section about how the rating agencies come in after the pools of mortgages have been allocated and give them a higher rating than the underlying tranches. That’s breeding the crisis of confidence—investors are not sure they can trust the ratings.

BTN—How is this affecting the buyouts across the nation and in Tennessee? What is going to happen going forward? Campbell—Many people are re-computing what they can pay on some of these buyouts. A lot of private equity folks have had to rethink the things they wanted to do a month or so ago. I think it’s going to have an impact on pricing going forward. Everybody would agree that multiples have been higher in the past year or two than they have been historically because of pretty cheap money—those multiples might start to go down.

BTN—How has this affected your work?

Harris—It’s definitely having an effect. We’re in the midst of some mid-market deals, and we’ve had lenders try to increase pricing as well as lower leverage multiples, and try to restore some stronger covenants. That has caused some disruption in several transactions that we’re involved in right now.

Quay—I’m working on a transaction with a division of a public company involving senior and sub debt. There’s a great deal of difficulty getting the transaction completed at the original multiples. I’m seeing the same thing on lower multiples, more covenants and more equity being required.

BTN—As far as recent Tennessee buyouts, does anyone have an opinion on why Dollar General purchase price was so low?

Campbell—I don’t have any particular insight. Stock had been lower in the year or two before that buyout than it ended up selling for, for whatever it’s worth. But I couldn’t really comment on that.

BTN—As companies talk to private buyers, what can they do to fare better in those deals?

Campbell—It seems like the company should be clear on why it does not want to be a public company going forward. Why are we making this switch, what are we giving up by not being a public company and what do we gain by being a private company, is this the right timing for us?

Quay—I’ve been reading about the Delaware court cases involving the Topps’ and Lear Corp.’s going-private transactions. They don’t directly affect Tennessee companies except to the extent that they are Delaware-incorporated. But the preliminary injunction was issued in both those cases because the proxy statement failed to clearly describe the reasons for going private and how the existing management was benefiting from the transaction. You wouldn’t think of a Delaware court enjoining a going-private transaction, but in both of these cases they did, due to the absence of full disclosure in the proxies.

Campbell—In a couple of recent proxies there’s been an emphasis on the interest of management, how their interest is different from that of the other shareholders. I suspect people are reacting to the impact of those two decisions.

Titus—We’ve been getting more pushback from the SEC on those portions of the proxy statements—demanding more disclosure and letting the public shareholders better understand how much the management is going to personally benefit from the transaction. Campbell—From a disclosure point of view, it’s certainly hard to argue with that emphasis.

BTN—Do you foresee more regulation? John, what is different with Sarbanes-Oxley now compared to 2004 when you wrote your article?

Titus—Much of what we saw and what we were predicting has come about. You see the conversion of a pretty liquid financial market that provided opportunity for private equity funds to easily finance the transactions coupled with an environment that has mitigated many of the benefits of being public.

Campbell—You do see that in practically every case, but on the other hand, for a company that does get a benefit from being public, the Sarbanes-Oxley law has made most boards of directors more focused and presumably more diligent. They operate more independently of management than they did five or 10 years ago. That was one of the intended effects of that statute, and I think it’s a good development.

Titus—I don’t disagree. When you talk to many of those private equity funds, they say that after a transaction they follow many of the same guidelines that Sarbanes would apply if they were public because their exit strategy involves subsequent IPOs down the road, so they’ve got to be prepared.

BTN—How is this affecting the industry today given that there are so few IPOs?

Harris—There are still companies going public. You’re seeing a lot more companies exit from being publicly traded, but there hasn’t been a huge chill on the number of IPOs. The greater impact will be the effect of the credit markets and the effect it’s having on the stock market, the level of volatility.

BTN—What is the average cost of Sarbanes-Oxley regulations to a medium-size public company? Is there a way to quantify that?

Campbell—You can put a million-and-a-half or a two-million dollar number.

BTN—How is this affecting your fees?

Harris—We’ve remained very active and continue to be very busy.

Campbell—Whenever you have a relatively new statute like this, it creates many issues and questions. Clients want to be careful and make sure they do the right thing. It creates additional work for people in our profession.

BTN—Which Tennessee public companies do you see as candidates for being taken private?

Titus—I don’t know that I can speculate on specific companies. In general, private equity funds look for companies that produce high cash flow and have low leverage on their balance sheet.

Harris—The health care industry shares many of those characteristics. That’s why many private equity firms are looking in Nashville because the health care industry generates strong cash flow, has strong management teams located here.

Campbell—If a company like Chrysler can go private, anybody can go private. Anybody potentially is a candidate these days.

Titus—It used to be limited to a few select industries, now you see companies across the board—everything from retail, health care, even manufacturing companies. And size isn’t a problem any more.

Harris—The one caveat is the disruption in excess volatility. The cheap money may be going away, and it may be much more difficult to finance acquisitions with such cheap credit. It may affect the level of going-private transactions.

BTN—Do you see any specific regulations that affect Tennessee in your work?

Campbell—So much of the legal work is done all over the country, there’s nothing unique to Tennessee. So many companies are Delaware entities anyway.

Quay—It certainly wouldn’t affect the going-private transactions, but the Tennessee excise tax on limited liability companies and limited partnerships is something clients have to deal with. It does have an impact on large companies that are based out of or have a nexus with Tennessee. I don’t see that causing businesses to avoid Tennessee. I realize there are overriding issues with revenue generation, but it’s one of the things Tennessee ought to reexamine to put it in line with other states.

Campbell—Everybody agrees that Sarbanes-Oxley makes it more costly to be a public company these days, but do you see any positive, real-life benefits among people you deal with because of that change in the law?

Titus—The law has resulted in more focus by not only outside board members, but management teams on internal control. Financial controls at most public companies are stronger than before Sarbanes-Oxley came into existence. My only question is—does it go too far with the smaller companies struggling to implement procedures that fit well with a large public company, but are simply beyond the financial means of smaller public companies?

Campbell—There’s definitely a dichotomy between "larger" public companies and some of the smaller companies.

Titus—They’ve struggled to figure out how to apply a lesser standard of controls on the boards of smaller public companies. All you have to do is go to a board meeting of a public company and everybody is very conscious of the Sarbanes obligations. And frankly, that wasn’t the case 10 years ago.

Campbell—We talked about some of the public companies going private and, Rob, the change in credit markets is certainly having impact there. But what about the private equity funds that are looking for middle-market companies? Do you think the change in credit markets is going to have an impact on that?

Harris—I certainly do. Private equity funds leverage the assets quite a bit, and to the extent that interest rates have gone up and covenants and terms are tighter, it is going to be more difficult to finance these acquisitions with this much leverage. So, despite having so much liquidity, if pricing moves against them, it’s going to chill the number of transactions a little bit.

Titus—It’s going to affect all middle-market companies, not just the ones backed by private equity. We see a number of health care companies right now trying to get debt financing done, and they are having a harder time than they did as recently as six months ago.

Harris—Two weeks ago!

Campbell—From the acquisitions point of view, does this mean that multiples should start to come down over a period of time? Harris4That’s a definite result. If they’ve got to pay more to the banks rather than the sellers, then acquisition multiples will definitely go down.

Quay—What are your thoughts on proposals in Congress to tax carried interest as ordinary income?

Titus—That’s an interesting proposal. We do some work with UK companies and are seeing the same proposal over there. It’s partly being spearheaded by the labor union activity as a response to private equity buyouts that have resulted in fairly significant layoffs, and it’s raising the concern of private equity funds. But carried interest looks much like a compensation arrangement.

Harris—It certainly seems much more fair. It gets the investment banks lined up against the private equity firms because they view that as a competitive disadvantage that private equity firms are able to pay so much less in taxes on their returns.

Quay—A publication by the Joint Committee on Tax that came out in July purports to show that private and public pension funds account for 42% of the investment in venture capital funds. I’ve been reading that if the tax is increased on the carried interest, it’s just simply going to be taken out of the returns of the pension funds. I think it’s causing them to rethink their position on the tax. The notion that the sponsors of these venture capital funds will take a lower pay out because taxes are higher is probably not true. It’s mostly going to come from somewhere else, and most likely from other people investing in the funds. What troubles me about this proposal is that it ignores the fact that in corporate context, if a corporation has been formed largely with preferred stock and a small amount of common (and the common’s held by management), you could argue that a small increase in that common stock looks a whole lot like compensation, and nobody would even begin to suggest that capital gains from the increase in the value of the business ought to be taxed as ordinary income. So I think that if it gets passed it’s likely to get vetoed.

BTN—Moving on to the day-to-day issues affecting your law practices. How does deeper specialization affect young attorneys in mergers and acquisitions? Do they have to unlearn what they just learned in law school?

Campbell—They don’t have to unlearn anything they learned in law school. Young attorneys can get up to speed much faster because many of them are looking at narrower and narrower areas. In some ways, it’s really good, but some young lawyers take a longer time to develop good judgment skills because they have been so immersed in one particular area and with one particular client. They don’t get a good cross-section of how to advise people.

BTN—How do you address that?

Titus—Rather than pigeon-hole new lawyers in certain areas, we try to give them more exposure to many different practice areas in their first year out of law school. If you specialize too early, you don’t get an appreciation for the area you’re in.

Harris—We assign lawyers to different client and industry teams. They see a broad cross-section of work.

Campbell—An obvious trend compared to the time most of us started practicing concerns the escalating salaries people are being paid when they come out of law school. There’s much more focus on making sure they are working profitably and as hard as they can. Years ago, more time was spent on training that was not necessarily billable to clients. That’s much less common today.

Harris—One trend I’ve seen is the use of e-mail, the necessity of an immediate response. Many clients will e-mail you something and expect an immediate turnaround, whereas previously, with faxes and letters, you had a chance to consider your response. Now attorneys are pressured to do the drafting while the client is watching and not to slow down the deal. Much of that is driven by private equity firms and large investment banks, as they expect quick turnaround on these deals.

Titus—Mostly, technology has distanced the lawyer from the client. In many of the transactions we do, we never ever meet the client. The days of everybody showing up in a conference room to exchange signature pages are long gone. Now you do it by PDF, scanning documents back and forth. It puts a premium on the ability of lawyers to connect with their clients because in many cases we don’t meet with them face-to-face anymore.

BTN—Does it cost more these days to actually meet the lawyer?

Harris—I don’t think it costs more, but it’s certainly more expensive to travel than send a PDF.

BTN—And what is the next step given this prevalence of instantaneous demand?

Quay—We’re seeing electronic data rooms, electronic diligence being circulated which years ago was unheard of. I agree that the days of in-person closings are unusual nowadays. And I think it’s not a good thing. It’s important to be in person at these closings, but given the speed at which the deals are closed, there’s no time to get on the plane to travel somewhere.

Campbell—I deal with lawyers from all over the country whom I talk to while working on a deal, and I never meet them or have a prospect of meeting them. You feel like you know a lot of those folks because you work with them on multiple deals, but you never get face-to-face at a closing or a meeting.

BTN—That’s one of the reasons why Concorde went out of business—because there’s no more need to cross continents at supersonic speeds to run into a boardroom and say “no deal.” Gentlemen, thank you for your time and interesting comments.