Buyout firms will start to use a higher percentage of equity and seek smaller deals at lower prices as they face an end to the easy money which fuelled an unprecedented wave of takeovers.
The shift is happening as lenders try to recover from the debt indigestion plaguing already-agreed acquisitions -- a $400 billion glut of buyout financing which banks have been unable to sell on to investors.
The fallout from the financing logjam is spreading, and this week started to force a number of deal talks to shut down.
Software provider Civica ended takeover talks with a private equity firm on Thursday because of debt market jitters and 3i Group scrapped the auction of its NCP towing services business after the prices offered were too low.
In terms of new deals, my ongoing assumption is that I'm going to be paying less for companies, but also paying with less leverage, said Bruce Raben, a partner at private equity firm Hudson Capital Advisors.
That widely held view was seen by many buyout executives as a welcome return to sanity after 18 months of debt at record low rates and lax lending controls, which led to inflated prices.
It's probably no bad thing for the market to cool down and reassess risk, 3i banking partner Andrew Golding said.
Although Golding and others expect a deeper impact on big buyout shops such as Blackstone Group and Kohlberg Kravis Roberts & Co. rather than mid-market firms like his own, Golding said everyone will feel it to some extent.
You can see enterprise values coming down in terms of multiples, he said. We'll be less able to gear up the businesses as much ... This is not a crisis, it's an adjustment.
Indeed, while private equity firms face financing worries from the current batch of deals, the broad sell-off in shares from credit market worries means buyout shops can get back to hunting for bargains instead of growth plays.
One strategy particularly at risk is elephant hunting, as it is known on Wall Street, or the megabuyout of large publicly traded companies worth tens of billions of dollars.
The borrowing required for such deals would be tough to squeeze through in the current climate, forcing large LBO firms to chase smaller deals, a trend that has started to play out in the last few weeks.
I do believe the bank market will reopen and will reopen for middle market type of deals first, said Steven Rattner, managing principal of media-focused U.S. buyout firm Quadrangle Group.
I think the chance of a megabuyout is on hold, reasonably indefinitely.
Easy borrowing allowed LBO firms to use only 20 to 25 percent equity in deals while borrowing the rest. That equation could shift to a higher threshold of 30 to 35 percent equity.
Average debt to EBITDA ratios in European leveraged buyouts swelled to 5.84 in the first quarter 2007 and 6.04 in the second quarter, according to Reuters Loan Pricing Corp., but is seen retreating to the 4 to 5 level used between 2003 and 2005.
Even with the recent credit market freeze, spurred by the subprime mortgage meltdown, the economy is holding steady and buyout professionals say it is too early to say if the chill will have a long-term impact on LBO firms.
I don't think what we're seeing threatens the overall model at all, said Simon Perry, global head of private equity at Ernst & Young.
I don't think we're going to see a sustained, fundamental credit crunch, he said. We're going to see a period of adjustment and overall that will be beneficial for the market.
In fact, leveraged buyouts of public companies still look appealing, with the average yield on trailing 12-month free cash flow for corporates at 4.45 percent compared to the average weighted cost of debt for those companies at 3.6 percent, according to Moody's.
This makes leverage more attractive given free cash flow is higher, Moody's analyst Christine Li said.
Even as private equity firms recalibrate their expectations and strategies because of credit market woes, most still anticipate steady dealflow to return by October.
The conditions in the market have been getting increasingly favorable over the last three years, said William Jackson, managing partner for UK private equity firm Bridgepoint.
Things can still retreat some way and still be pretty good.