Private Equity Is on a Roll, but Are Investors in for a Let-down?

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With private equity investors of all types flush with cash — from venture capitalists and hedge funds to large leveraged buyout (LBO) firms such as The Blackstone Group and The Carlyle Group — private financing hit record levels in 2006 and is likely to remain strong in the new year, according to Wharton faculty and industry analysts. Nearly a third of the dollar value of all U.S. acquisitions last year involved private equity firms, up from just 3% five years ago, according to U.K.-based Dealogic, which tracks the investment industry.


General Electric reportedly has invited private equity firms to bid for its plastic divisions in a deal that could be worth more than $10 billion. The nation’s largest casino operator, Harrah’s Entertainment, is weighing a $15.5 billion bid from a team of private equity players. In November, shareholders of hospital company HCA approved a $33 billion private-equity buyout, topping the prior record of $31.3 billion paid for RJR Nabisco in 1989. The RJR Nabisco deal, chronicled in The Barbarians at the Gate, has come to symbolize the 1980s buyout era that ended with the crash of highly visible junk bond deals.


With $660 billion in corporate buyouts last year and a war chest of $750 billion still to deploy, private equity investors are on a roll, but concerns about the sector’s ability to deliver sizeable returns are also welling up. Angel investor Rob Weber’s first reaction was surprise when a hedge fund swooped in a few weeks ago to snap up the entire $10 million second-round financing of a life sciences startup he owns. He flashed back to the high-tech boom that went bust in 2000. “A warning flag went up in my head,” he says. “I hope we’re not in for a repeat of the bubble era.”


Wharton finance professor Pavel Savor echoes the note of caution. “Everything is very peachy now, and maybe the only way to go is down, but I would say that nothing is imminent,” he says. “Last year was the best on record by size, and 2007 in all likelihood will be even better in terms of activity. Whether it will be a good year for investors is an open question.”


Savor says lenders remain eager to accommodate buyout firms, and debt ratios are nowhere near the alarming levels that led to the junk-bond collapse following the buyout binge in the late 1980s. “A couple of high-profile bankruptcies could change that,” he warns, “but for now, the buyout shops have a little space to breathe.”


Much of the investment in private equity has been concentrated at the industry’s largest and best-known firms, Savor points out, noting that investors are eager to place investments with the top firms because they tend to get better terms than with smaller companies. And, in order to preserve their reputations for future deals, the big players are also less likely to let firms they control go bankrupt. “They have career concerns and do not want to default,” Savor says.


New Roles for Private Equity


According to Wharton management professor Saikat Chaudhuri, the rush to fund private equity is blurring some of the lines that were once drawn between venture investment, hedge funds and leveraged buyout companies. Hedge funds, which once focused mainly on public companies and had a short-term horizon, are now also delving into privately held firms and even small venture-type investments that may require patience. Private equity firms, often working together in teams, are now going after increasingly large deals that once were considered so big only the public markets could provide financing. “Private equity firms are no longer spreading themselves thin in a lot of investments,” says Chaudhuri. “Now they are going after more mature investments even if there is a smaller return, but that’s better than just parking the money or not doing much with it.”


As buyout deals grow larger, firms may find that simple financial engineering techniques will not create enough new value to generate the kind of above-average returns that many private equity investors have come to expect, adds Chaudhuri. Typically, buyout firms come into a new company and can quickly create value with a new financial structure, simple operational fixes or big cuts in the workforce. “As you start to get into these large deals — in the double-digit billions — that’s going to require management expertise in the field and probably also holding the company for a longer period of time.”


Wharton finance professor Andrew Metrick says there should be little concern that shareholders are being shortchanged in the large buyout deals. In the wake of public scrutiny following the scandal at Enron and the 2002 Sarbanes-Oxley Act, operating a public company has become more difficult and potentially less efficient for many managers. “There are executives who believe their companies are worth more and would function better in the hands of private owners,” says Metrick.


In the past, he adds, private ownership was considered less efficient than a public structure because it tended to concentrate equity in the hands of just a few owners. Now, however, large buyout firms spread ownership widely because most of their partners are often big investors, such as pension funds.


He also points out that the major LBO firms that have been generating a lot of publicity are growing, but are still dwarfed by the public equity markets. He estimates that after leveraging their capital, private equity firms would be able to target $2 trillion in U.S. investment. By comparison, the public equity markets are valued at $13 trillion. “Private equity was historically a niche industry,” says Metrick. “It got a lot of press in the 1980s when it first emerged, but throughout most of the 1990s was small relative to the public markets. Now it’s become noticeable again.”


Harry W. Clark, managing partner of Stanwich Group LLC, a Greenwich. Conn., consulting firm, says it is unlikely that a large private equity buyout firm will ever make a hostile bid for a public company. “You may see more actively hostile actions by hedge funds, but for the serious, mature players in the large private equity sector, the nature of their business lies in a relationship with management.” Major investment banks, however, may begin to carve out new business as consultants to public companies that want to develop strategies to compete with the private equity funds, he adds.


Chaudhuri suggests that the rise of private equity buyouts is putting pressure on public company management, but that it may also be a transitional phase as the economy rebounds from the weakness that began with the technology investment crash of 2000. Companies that fall under the control of private equity firms, he argues, will ultimately wind up in the arms of strategic buyers in their own industries. Those transactions will bring firms to the next level of business innovation and productivity. “After the boom, there was a slowdown and a lot of firms were struggling. As they are rebuilding themselves in a growing economy, the strategic buyers are not yet in a position to consolidate,” Chaudhuri says. “The private equity firms are coming in and streamlining some of the companies. Eventually, in my view, they will be sold to strategic buyers once again.”


Too Much Money, Too Few Deals


In the venture investment sphere, Raphael Amit, Wharton professor of entrepreneurship and management, says the picture is mixed. On the positive side, activity is strong and even large investment firms are willing to take on small, seed and first-round financing. “That’s very good news for innovation in the United States. These top-tier firms used to not want to do small deals. Now they are willing to do them just to get their foot in the door.”


On the downside, he says, returns are, on average, close to those of the S&P 500, with only the best-known firms generating returns of 30% to 40%. “The top-tier firms are completely oversubscribed. If you want to [get into] the sector, you should only invest in them, but they’re not taking in any new investors.”


Amit points to Sevin Rosen, a prominent venture firm with offices in Silicon Valley and Dallas that raised more than $200 million from investors last year. This fall, Sevin Rosen sent the money back, saying it could not invest the cash productively because there were already “too many deals funded in almost every conceivable space.” Sevin Rosen also cited a weak exit environment for private investors hoping to cash out through an initial public offering (IPO).


Amit says liquidity events, such as an IPO or a sale to strategic buyers in the same industry, are now taking much longer than they once did. In 1999, it took less than two years for investors to cash out of an investment through an IPO, but in 2006 it took more than five years, he notes. The timeframe has also expanded in the other chief form of private equity exit — merger and acquisition deals. In 2001, it took an average of about 18 months to do a sale or merger, but by 2006 the timeframe had stretched to more than five years.


Savor points out that private equity firms may shift toward a completely new model in which funds hold companies longer and repay their investors through dividends. “In the past, IPOs were the preferred exit, and I would say they will remain so in the future,” he says. “But if for some reason they do not, private equity shops will find other ways to monetize their investment — as long as there is something to monetize.” While U.S. public offerings have been limited, Amit points out that exchanges in London, Hong Kong and elsewhere have been sponsoring a healthy number of new listings. According to Metrick, private equity firms may also cash out of investments by selling to other private equity firms.


Wharton management professor Mauro Guillén says private equity will continue to play an important role in Europe, where companies are still undergoing restructuring related to the creation of a single European market and the subsequent expansion of that market into new countries. “I don’t think there’s been enough M&A and LBO activity. Private equity is a part of this whole story in Europe. I don’t think we’re anywhere near the end of this,” says Guillén. “The adjustment by business in terms of the restructuring and consolidation of industries has been lagging behind the great progress made in expanding the size of the market and removing barriers. I think it’s going to keep going for a long time.”


Guillén is less optimistic about continued private equity strength in Latin America following moves in several countries toward more populist policies. He points to Venezuela, where newly re-elected President Hugo Chavez has vowed to nationalize the nation’s power and telecommunications sectors. In Asia, China continues to be a draw for all forms of capital, including private equity, says Guillén. India, too, presents opportunities. While India has some modern, highly efficient industries, such as software development and business services, many sectors are in dire need of the kind of restructuring that attracts private equity investors.


The boom in private equity finance has drawn the attention of regulators. In Britain, the Financial Securities Agency (FSA), which oversees financial markets, issued a report in November stating concerns that the U.K. private equity market is overextended. The U.S. Department of Justice this fall sent letters of inquiry to several major private equity firms. The focus of the probe appears to be on large consortium, or so-called “club” deals — in which private equity firms combine to take on large transactions — and on whether the firms may have collaborated in some way to reduce the price of the bid.


Chaudhuri says increased regulation in the United States is not likely unless a major deal goes sour. “I do think some pressure will come, so this free rein is no longer going to be there. If one of the largest deals doesn’t do so well under private equity, that’s when [we will see] some regulatory pressure.”


Weber, the angel investor who is also chief executive of Intellifit, a start-up that markets guaranteed-fit technology for on-line apparel shopping, says he had been hearing about hedge funds moving into traditional private venture investing. “It seemed illogical to me,” he says. “Then suddenly it was in my own backyard.”


Weber says today’s buyout environment is less perilous than in the era of Gordon Gekko, the buyout artist portrayed by actor Michael Douglas in the film Wall Street, who famously proclaimed that “Greed is Good.” In those days, Weber says, the use of junk-rated debt fueled the excess. Still, he finds it worrisome when hedge funds get involved with start-ups because they may not have enough experience in the volatile venture world to help make their investments succeed. “Everybody’s happy when things are up, but when they are bad, I’m not sure how prepared a hedge fund will be to navigate the rough waters of an entrepreneurial start-up.”


Weber is also concerned about the risk that private equity firms themselves are engaged in a sort of ponzi scheme in which buyout firms sell companies to one another at increasingly high prices that ultimately will crash. “Having lived through the bubble era, when I see irrational exuberance, or signs of it, I get a bit concerned because the venture industry has worked hard to return to sanity and an era of logic,” says Weber. “I was starting to feel good again about the work we do. I still do, but now I have this flag that has gone up which is causing me to be a little bit worried.”

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