What Does Private Equity Indicate?

By Arthur Pinkasovitch | January 28, 2010 AAA

As the economic recovery progresses, investors are eager to ride the next market rally. The financial sector has led a recent 5% stock market pullback due to president Obama's commitment to regulate banking activity. However, investment opportunities ranging from index funds to Berkshire Hathaway (NYSE:BRK.B) shares, which are now incorporated into the S&P 500, present fairly safe investment alternatives. The announcement that the U.S economy has grown an extraordinary 5.7%, combined with the market upturn since March, will likely encourage more companies to go public in 2010. This is good news for private equity firms. They will see their business expand and their shares appreciate. Investors may want to take their cue from the higher activity levels of private equity firms and see if the market fundamentals are right for personal investments. (For an introduction to private equity, read What Is Private Equity?)

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Blowing Bubbles
At the height of the technology boom, the 2000 initial public offering (IPO) volume was a staggering $96.9 billion based on 406 transactions. Public offerings decreased after the bubble burst and have yet to return to that level. The 2007 IPO volume was only $59.7 billion from 272 transactions. The IPO environment has been very quiet following the collapse of Lehman Brothers. 2009, a year where many private equity firms watched their stock prices hit rock bottom, saw only 63 IPOs with a cumulative value of $21.9 billion. Most of these came near the end of the year. If the market momentum of the latter part of 2009 continues into 2010, shares of private equity firms may once again become a lucrative investment opportunity. However, if you look at private equity transactions as a leading indicator for the overall stock market, then ETFs such as the SPDR S&P 500 ETF (NYSE:SPY) could be a good addition to your portfolio in lieu of private equity firms.

Watching The Buyout Artists
KKR
(NYSE:KFN) and The Blackstone Group (NYSE:BX) are some of the largest private equity firms in the world. KKR is reportedly set to buy Pets at Home for $1.5 billion. Deals of this magnitude were absent during the credit crisis, and their return is a positive sign for the stock market. Blackstone has a diversified portfolio of holdings ranging from Allied Waste, a waste management firm, to The Weather Channel. Both companies have been stirring from their slumber.

Quantity, Not Quality

Private equity analysts can be wrong about forecasted economic conditions. For example, Lone Star Funds purchased Accredited Home Lenders in August of 2007 for $400 million, only to see it go bankrupt. The wisdom of the deals is not as important as the fact that these deals are being made. The positive correlation between private equity transactions and stock market returns means that the activities of these firms can be viewed as the leading indicator to the broader market. Some people do, however, view this as a lagging indicator of economic busts. The rationale being that private equity firms start buying at the bottom to lead the recovery, but keep buying long after the market is overvalued - lagging the eventual correction.

The Bottom Line
The days of Michael Milken's junk bond machine are long passed, but credit still play an integral role in private equity transactions. Consumer spending is slowly increasing and banks are becoming more lenient with providing credit, even though other parts of the economy, notably employment rates, haven't bounced back. These easier credit conditions, along with escalating share prices, allow private equity firms to provide higher returns for their shareholders. And when private equity firms start earning profits, it is usually a sign for investors to think about jumping into the market. (To learn more about leveraged buyouts, check out Understanding Leveraged Buyouts.)

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