Private Equity Funds: Two Ways to Play the Coming $1.6 Trillion Private Equity Boom
by Louis Basenese, Advisory Panelist
July 2, 2007: Issue #687
A Note from Alexander Green: Today's message is from my friend and colleague, Louis Basenese, our mergers and acquisitions specialist. 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.