Private Equity Well Drying Up

By Ryan Barnes | August 22, 2007 AAA

One of the crucial side effects of the tightening credit markets we're currently seeing on Wall Street involves a potential cut in the size and number of private equity deals.

For quite a while now, and especially in the past 12 months, private equity deals have gone big-budget, mainstream, and high-profile.

The buyouts have gotten larger, with $30+ billion becoming the new high benchmark, as the so-called club deals became more frequent, and necessary. Meanwhile the universe of potential target companies spread out from the conventional stock models to include just about every industry in the equity playing field. As a potential sign of saturation, Blackstone Group founder Steve Schwarzman is named one of the "100 Most Influential People in the World" by Time magazine in 2007. (For related reading, see Private Equity Opens Up For The Little Investor.)

But if you notice, the pace of deals has slowed down dramatically in recent weeks, and in fact most news coverage these days centers on whether all the debt created by these deals will be able to be sold to investors via the debt markets. The storm raging through the subprime and asset-backed securities markets is not yet over, but enough of the smoke is clearing so that we can ask ourselves if private equity really has any legs left.

It seems that the fair way to answer the question is to look at the key drivers that made private equity such a force in the stock market over the past few years. Let's take a minute to remind ourselves what a unique set of events brought this buyout mania to our markets.

Private Equity Driver #1: Low Current Stock Valuations
Thanks to several years of solid growth and record corporate earnings, current earnings valuations on the S&P 500 dropped to historically low levels. This obviously made the math surrounding many private equity deals favorable, essentially dropping the purchase price to acquire a company's outstanding shares.

Current State:
While current valuations are still on the low end, concerns about future earnings and the economy are putting future earnings projections at risk. A strong stock market in the first half of the year pushed many valuations back into normal ranges.

Private Equity Driver #2: Cheap Credit
Access to cheap credit came from a combination of very low interest rates and yield-starved investors who eagerly bought the debt used to finance privatizations in the secondary markets. Investment banks were eager to set up funding, earning fat fees for their efforts.

Current State:
Not good. While interest rates remain low on the whole, investors are scaling down their risky investments across the board, especially large institutions that are unwinding shaky fixed-income securities. Large deals such as Chrysler's $12 billion offering have been postponed already, and there are hundreds of billions of dollars in debt surrounding in-process buyouts that have yet to be sold to investors. In order to get just the current deals done, private equity firms may have to pony up to higher interest rates to appeal to today's more risk-averse investor.

Private Equity Driver #3: A Favorable IPO Market
Let's all be honest with ourselves. Most private equity deals are done with the hopes of re-spinning the company as an IPO down the road. When IPO markets are hot, most new issues hold up well, and make the owners fortunes. When dried up, IPO markets become a desert wasteland, with most parties sitting on the sidelines waiting for someone else to jump into the fray first.

Current State:
IPO markets have been weak for most of 2007, and new issuance will continue to dwindle as the pullback of the broad indexes and concerns about the economy continue to loom over the market. Many IPOs of 2007, including the much-touted Blackstone Group (NYSE:BX), are trading lower than their original offer price. Many recently announced LBO deals, such as Sam Zell's buyout of Tribune, are being done at debt multiples (ratio of company debt to cash flow) of 8- or 9-times cash flow and higher - extraordinarily high ratios that will need to come down before investors will seriously wish to own them as public companies again.

Private Equity Driver #4: High Levels of Fund raising
New private equity funds were being closed at record rates and at record sizes during 2006 and 2007, thanks to stellar returns from private equity funds, along with their new-found publicity. Investment banks such as Goldman Sachs (NYSE:GS) and Merrill Lynch (NYSE:MER) were able to raise tens of billions of dollars from investors, with each new fund eclipsing the record size of the prior one. This effectively loaded the guns of private equity, and allowed them to pursue more, and larger, target companies.

Current State:
The ability to raise funds hasn't really been tested yet because most of the big players have yet to exhaust their existing cash. This is due to the screeching brakes in the credit markets and the current backlog of debt yet to be sold.

Private Equity Driver #5: Favorable Tax Status
Thanks to the way private equity firms record their revenues and profits, they have enjoyed an enviable tax status, often paying less than 15% compared with the standard 30% rate seen in Corporate America.

Current State:
Lawmakers are going after this loophole with increasing intensity, especially now that some private equity firms are going public. It is very possible that new legislation will close this gap, which would dramatically change the math on a lot of future deals, and put many that would have been done 18 months ago out of reach.

Summary Thoughts
All in all, I feel we've seen the peak of private equity activity; in fact I am nervously awaiting the first major default on a LBO-based bond. That's all it could take to put enough fear into already scared credit markets to drive up interest costs to a level at which most deals just don't make financial sense anymore.

So, what's a retail investor to take from all this? I would suggest taking a hard look at investments within industries where stock prices have been buoyed by prospects of buyouts, as this premium may quickly fade from the market. (For more information, check out Cashing In On The Venture Capital Cycle.)

Looking to cook up a market-stomping stock portfolio? Check out our FREE report "7 Ingredients to Market Beating Stocks" and get started right now!

Related Analysis
  1. These stocks have been weak, and despite rallies, investors might be better served by selling or shorting as opposed to buying.
    Chart Advisor

    Time To Take Profits On These 4 Rallying Stocks?

  2. With its huge population and booming economy, China is tops for many emerging markets investors. Here's a leveraged ETF for those who want to double down.
    Stock Analysis

    This Leveraged ETF Is For China Bulls

  3. Chart Advisor

    Is Natural Gas About to Tank?

  4. Stock Analysis

    Pharma Industry Outlook: M&A, Licensing Abound - Industry Outlook

  5. Chart Advisor

    Is It A Breakout? See The Point-And-Figure Chart

Trading Center