Private Equity Funds

Private Equity Funds: Two Ways to Play the Coming $1.6 Trillion Private Equity Boom

by Louis Basenese, Advisory Panelist, The Oxford Club
Wednesday, June 27, 2007: Issue #687

A Note from Alexander Green: Today’s message is from my friend and colleague, Louis Basenese, our mergers and acquisitions specialist at The Oxford Club. Lou regularly analyzes companies that are strong buyout candidates. And with private equity funds at record levels, he’s had quite a lot to keep an eye on. Here’s Lou’s take on the private equity boom, and why it’s not likely to end any time soon. Alex

Private equity buyouts accounted for one out of every four mergers and acquisitions last year. In all, there were 654 deals. And private equity funds weren’t just busy snatching up public companies

They were also busy raising $401 billion in cash. That’s up 29% from 2005’s record-setting pace.

This year, the funds are still piling up – good news for the ultra-wealthy investors who contribute to these funds, but great news for companies on the takeover list and anyone holding their shares. Here’s why

Private Equity Basics

Private equity generally refers to any type of equity investment that doesn’t trade freely on a public market.

Most are structured as limited partnerships and focus on investments like corporate buyouts, venture capital, angel investing and mezzanine capital (subordinated debt that includes some type of equity stake).

For our purposes here, when I talk about PE, I’ll be referring to the buyout funds. They are the ones snagging all the headlines and attracting all the capital. And they should be – they’ve compiled quite a track record of blockbuster returns, sometimes in excess of 40% and 50% per year.

They do so by snatching up publicly-traded companies, often paying a steep premium to close the deal. That’s why holding shares of a takeover candidate can result in substantial overnight gains, literally.

Then the private equity funds find better ways to run their newly acquired companies, and then flip them later for a profit, either to another private company or back to the public through an IPO.

Typically, PE firms load up the balance sheets of the acquired companies with debt to minimize their cash outlay and increase their potential returns through leverage. Hence, during the last boom (in the late 1980s), these firms were often referred to as leveraged buyout funds (LBOs).

The Private Equity Boom Continues In 2007

According to Dow Jones Private Equity Analyst, the first quarter saw a 67% increase in total funds raised over Q1 last year.

But the leverage these cash-rich PE firms apply that has turned last year’s $401 billion in fundraising into roughly $2 trillion in potential buying power – of which only $390 billion has been deployed.

Bottom line: there’s a hangover of at least $1.6 trillion and that’s not accounting for future fundraising. You can be sure it won’t sit dormant.

What’s more, credit spreads are the thinnest since World War I. For buyout funds, the cheap debt is like pouring gasoline on the fire.

To be sure, the PE boom still has legs.

Two Ways to Profit From Private Equity Funds

1. If you’re after the most bang for your buck, then you need to focus on the companies that are the target of private equity funds

Candidates here are companies that generate a strong cash flow, operate a stable and predictable business, and trade at a reasonable valuation.

These three criteria ensure the company will be able to cover the hefty debt payments, survive any economic downturns and provide enough profit for the PE firm to achieve its required rate of return.

2. If you’d rather take the guesswork out of the game, then buying into one of the PE firms themselves is a good alternative

But realize this: your shares will represent an interest in the management company, not the funds themselves.

Here are the major players, including private, public, and soon-to-be public firms: Blackstone Group, Bain Capital, Carlyle Group, KKR, Thomas H. Lee Partners, Apollo Management, Kohlberg Kravis & Roberts, the Texas Pacific Group, and Elevation Partners, and American Capital Strategies.

Good Investing,

Lou

Editor’s Note: Several private equity companies in particular are positioned for exceptional returns. In our latest special report, we’ve highlighted the top four firms. Below, you’ll find the story behind the very first private equity deal.

Today’s Investment U Crib Sheet – The First “Private Equity” Deal

Around the turn of the last century, three of the country’s wealthiest and most powerful men were preparing to pull off the largest private financial transaction in the history of the world.

And two of them were poverty-stricken “street kids” from Pittsburgh. One earned pennies a day as a bobbin boy at the local mill.

The company they created was U.S. Steel, and the friends were Andrew Carnegie and Henry Phipps.

Carnegie and Phipps struck it rich as U.S. Steel became one of the most powerful companies in the world. And when the time came for retirement, they agreed to sell the company.

They privately contacted J.P. Morgan and struck a deal to sell him U.S. Steel for $480 million dollars. They wanted the cash; Morgan wanted the company (and the tremendous income it produced).

Once the deal was finalized, Morgan sent a note to Carnegie: “Congratulations, you are now the richest man in the world.”

But while Carnegie was busy stealing headlines, Phipps – who suddenly found himself richer than ever before – realized something magnificent:

Buying and selling whole companies on the private market could generate more profit than the regular stock market.

Realizing this, Phipps decided to use $50 million from the proceeds of the sale to create a special fund specifically for buying and selling private companies.

He called the fund The Bessemer Trust. Today it’s worth $46 billion dollars. And for 100 straight years, it has grown by 919% annually – through the acquisition and eventual sale of private companies.

Imitators were sure to pop up as other ultra-wealthy investors discovered the magic behind Phipps’ formula. Today we call them “private equity” funds.

To get involved, here’s the best way.