Private Equity's Nuclear Winter

On the face of it, the 18% haircut reducing the price of Home Depot's (NYSE: HD  ) supply unit to $8.5 billion is good news for the buyout's private equity sponsors, including Bain Capital, the Carlyle Group, and Clayton, Dubilier & Rice. It also seems to be good news for the lenders on the deal -- JPMorgan Chase (NYSE: JPM  ) , Lehman Brothers (NYSE: LEH  ) , and Merrill Lynch (NYSE: MER  ) -- which will have less exposure to their balance sheets.

But it's really just a short-term benefit. If anything, it's a sign that the private equity game will be in the penalty box for a long while. Home Depot was compelled to renegotiate the price after the lenders, reportedly, offered to pay a penalty to get out of the deal. 

Just a few months ago, it looked like private equity was a near-perfect market. Debt financing was dirt cheap, and many firms wanted to opt out of the public markets. KKR's founding partner, Henry Kravis, called it the "golden age" for private equity.

But the subprime mortgage crisis infected the buyout debt markets. Simply put, lenders wanted higher yields on their hard-earned money. Yes, private equity is not so golden anymore.

As for the Home Depot deal, it makes sense that it has undergone an extreme makeover. The housing market continues to deteriorate and the company needs the cash for its massive stock buyback.

Meanwhile, Wall Street seems to have its attention on buyouts of companies in much better shape, such as TXU (NYSE: TXU  ) and First Data (NYSE: FDC  ) .

The unavoidable issue is that major banks have committed to the financing of these megadeals. But with the sudden re-pricing in the debt markets, large writedowns on these loans seem inevitable.

With so much money at stake, I think we'll see not only contentious negotiations, but also brinkmanship. Take a look at the buyout of SLM (NYSE: SLM  ) , which operates the Sallie Mae school loan business. The private equity buyers, J.C. Flowers & Co. and Friedman Fleischer & Lowe, have hinted at triggering the "material adverse change" (MAC) clause and walking away from the deal. A MAC clause is usually for highly unusual situations, such as a major deterioration of the seller. Yet SLM's business seems to be fine.

Another possibility is that private equity firms may abandon a variety of deals and simply agree to pay the "reverse termination" fees, which range from 1% to 5% of the deal value. This may actually be cheaper than going ahead with a deal. According to a piece in The Wall Street Journal, the lenders on the Home Depot deal actually offered to pay this fee to unwind the transaction. Is it any wonder that Home Depot felt compelled the renegotiate?

The upshot is that Wall Street will be gun-shy on major buyout deals, which means that the private equity fee machine will sputter. At present, the market's just too busy dealing with the volatility of hedge funds, subprime exposure, and the problems of securitization. In other words, it looks like lean times have finally arrived for Wall Street dealmakers.

For more Foolishness:

Home Depot is a Motley Fool Inside Value recommendation. JPMorgan is a Motley Fool Income Investor selection.

Fool contributor Tom Taulli, author of The Complete M&A Handbook, does not own shares mentioned in this article. He is currently ranked 2,509 out of more than 60,000 in CAPS. The Fool has a disclosure policy.


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