Private Equity Keeps Booming
Firms swimming in cash will likely stay strong. But a slowdown could help prevent the development of a bubble
The latest boom in private equity is more proof, should anyone need it, that the rich keep getting richer. Global mergers and acquisitions by financial sponsors, or private buyout groups, hit $570 billion during the first nine months of the year, up 51% from the prior record set during the first nine months of 2005, according to market researcher Dealogic.
Private investors are playing a bigger role in M&A, which has traditionally been dominated by large, publicly held corporations. Financial sponsors accounted for 22% of the total announced M&A volume during the first nine months of the year, up from 18% during the first nine months of 2005, Dealogic said. (Discuss the trends at Deal Flow.)
CASH RICH. Experts say the growing power of buyout specialists such as market leader Blackstone Group, and other major players like Texas Pacific Group and Kohlberg Kravis Roberts, stems from their earlier successes. "My view is that the private equity megafirms are able to raise large funds and do large deals because they have had top returns, and now the big public and private pension funds want to invest in the private equity market," says John O’Neill, a partner and private equity advisor at Ernst & Young Transaction Advisory Services. Returns in the private equity sector can be as high as 50%, he said. Pension funds are increasing their allocations in private equity, O’Neill said. That’s because they’re reinvesting the profits taken from recent private equity investment to supplement those allocations.
The flow of cash means that private equity firms are raising larger funds and doing larger deals. In years past, private equity funds were typically several billion dollars in size. They were used to acquire small to medium businesses in sectors such as machine parts. Blackstone and other players now have funds in the $15 billion range—and they’re buying larger and larger businesses. Earlier this year, Bain Capital Partners, KKR, and Merrill Lynch Private Equity (MER ) set a private buyout record with the $32.7 billion acquisition of health–care company HCA (HCA ). It broke the record set in 1988 by KKR’s historic buyout of RJR Nabisco for $31.4 billion, including debt.
Private equity firms like companies with stable cash flow. And right now, large companies present more stable targets than smaller ones, O’Neill says. The targets are spread across a variety of sectors, from health care and retail to tech buyouts such as software company SunGard and chip maker Freescale Semiconductor (FSL ) (see BusinessWeek.com, 9/12/06, "Bidding on Freescale Sets Off Alarms").
SOLID OUTLOOK. Can the boom last? It’s unlikely to continue setting records at the current pace, but private equity will probably remain strong for years to come. The combination of a reasonably strong economy and buyers and investors with loads of cash almost certainly suggests a solid outlook for buyouts.
Yet a slowdown from the current pace of growth might actually be good. An easing in the rate of growth could discourage investors from bidding up the price of deals to unsustainable, bubble–like levels. A slower growth rate might also discourage buyout firms from loading up their acquisitions with too much debt. Some experts worry that debt levels are creeping too high. Investment banker Ken Marlin, of Marlin & Associates, says that debt measured as a multiple of earnings has reached "absurd" levels in some deals. Multiples have increased from three or four times earnings to six or seven, or more (see BusinessWeek.com, 8/29/06, "The Rising Tower of Debt"). If buyers feel that the economy is slowing down, or that they might not be able to generate enough earnings to support so much debt, they are likely to borrow less.
But even as the Dow sits near record territory, financial advances in the public markets still lag behind those of the private sector. Big institutional investors seeking double–digit gains are likely to stick with private equity for one, simple reason: There’s really no comparable alternative.