Private Equity: a Primer
Public offerings by big private-equity firms like KKR and the Blackstone Group have generated lots of headlines lately. But this rareified form of finance remains opaque to many investors. The following FAQs help explain what private equity is, why it matters, and how ordinary investors can participate.
What exactly is private equity?
The term refers to a class of investments that are privately owned rather than publicly traded in the stock market. Private-equity firms such as the Blackstone Group, the Carlyle Group, Kohlberg Kravis Roberts & Co. (KKR), and TPG launch funds through which they raise capital and borrow money to buy troubled or under-performing publicly traded companies. These days, private-equity funds are targeting companies of all sizes, including huge industrial concerns. For instance, earlier this year, Cerberus made history when it announced a plan to acquire a majority stake in the automaker Chrysler.
Is private equity a new development on Wall Street?
Not exactly. KKR, which recently acquired Dollar General, put private equity on the map in the late 1980s with its famed hostile takeover of RJR Nabisco. You might recall that this leveraged buy-out was the focus of the bestselling book Barbarians at the Gate. Today, some of the nation's leading businesses are owned by private-equity firms. Among them: Metro-Goldwyn-Mayer, Toys "R" Us, Dunkin' Donuts, and Neiman Marcus. Moreover, one of the leading Republican candidates for president, former Massachusetts Gov. Mitt Romney, has strong roots to the private-equity community–he made his personal fortune running the private-equity firm Bain Capital.
What is new, though, is the sheer size of the current wave of buyouts. So far this year, private-equity deals have accounted for nearly half of all merger and acquisition activity, based on dollar values, according to Thomson Financial. That's up from less than a third in 2006. And this is at a time when M&A activity is hitting record levels.
"Public-to-private deals continue to fuel the market," explains Greg Peterson, a partner in PricewaterhouseCoopers's transaction services group. Going forward, he predicts, the level of activity will depend on the amount of cash available to finance deals and the availability of takeover targets that offer investors sizable returns. Sectors ripe for more deals, according to PricewaterhouseCoopers: financial services, telecommunications, media, and software.
Is this a good trend for the markets?
It's hard to say. That judgment may have to be made on a case-by-case basis. For instance, some would argue that there's a real value-minded approach to these private-equity deals. After all, these private investors are looking at troubled or stagnant businesses that are often neglected or punished by short-term-minded stock investors. But at the same time, the goal of private-equity investors isn't to hold the business for a lifetime. As soon as they've invested enough capital in a struggling business to turn it around, they're looking to sell it. So it's not as if these firms are buying businesses with the same mind-set as, say, Warren Buffett.
What's been driving the boom in private equity?
Part of it is good old-fashioned greed. In recent years, some of the most successful private-equity firms have generated returns for their investors about three times as high as those the stock market has delivered. And many investors want in on the action. This may explain why institutional investors–including pension funds and charitable foundations–have become much more willing in recent years to invest outside of the traditional stock market in an effort to boost their potential returns.
But another contributor to the private-equity craze has been the supply of money available. Since the Federal Reserve eased monetary policy in the wake of 9/11, there's been a huge amount of liquidity that's been sloshing around the world's financial markets. And some of this cheap money was bound to find its way into private-equity funds.
Moreover, despite the stock market's recent gains, many investors believe that domestic companies are still trading at attractive prices relative to their earnings growth, and growth potential. The values that these private-equity funds see in the publicly traded stock market represent buying opportunities.
And finally, there's the interest-rate environment. By historic standards, market interest rates are still low, and this has made the cost of borrowing money cheap for private-equity firms. Remember, even though private-equity firms raise funds from large investors to buy out business, they still rely on a good deal of debt to help finance these deals. Of course, in recent weeks, market rates around the world have started to creep up, and some worry that this might remove a big tail wind propelling the private-equity market boom.
Is there a bubble forming in the private-equity market, like the technology stock craze of the late 1990s?
It's important to remember that private equity is not an asset like a tech stock, but rather a vehicle through which investors can purchase assets. So it's hard to imagine that a bubble is forming in this market. "Whenever people talk about a private-equity bubble, I cringe," says Tobias Levkovich, chief U.S. equity strategist for Citigroup Investment Research. He notes that while private-equity deals account for a high percentage of M&A activity based on dollar values, "at most, private equity accounts for only 25 percent of all deals." That means so-called strategic buyers–i.e., publicly traded companies buying other publicly traded companies–still account for the vast majority of M&A deals based on volumes.
What's the allure of taking a company private?
The thinking behind this strategy is simple. By taking a publicly traded company private, you remove it from the spotlight of the stock market. And some companies with major problems to fix or challenges to address–for instance, those with the need to come up with new products, strategies, or management–may perform better without Wall Street's persistent demands for high profits, quarter in and quarter out. Of course, once a company is fixed, its private-equity owners will quickly try to sell it or take it public again. In this sense, it's sort of like flipping a house. After investing money in necessary fixes, private-equity firms will attempt to resell the asset at a much higher price than they originally paid for it. Whether the company is sold or taken public again, the limited partners who invest in the fund benefit from the proceeds of the sale.
So if there's a benefit to private ownership, why are so many private-equity firms deciding to go public themselves?
That is the $64,000 question. Some of this may simply be a desire to make a fast buck while the private-equity trend is still hot. Remember, whenever a private business is taken public, the owners of that company can cash out with tens of millions of dollars. But there's more to it than that.
If private-equity firms truly believed that private ownership was the best road to riches, they'd remain private themselves. But the fact that a number of private-equity firms are now going public may be a reflection that these firms think the environment for raising money is becoming more challenging. For example, borrowing costs for private-equity funds are rising, as market interest rates creep higher. By going public, these firms will be able to tap into a huge resource–i.e., the stock market–to raise funds quickly and efficiently to help finance some of their deal activity.
How can individual investors join the private-equity party?
At present, it's really wealthy individuals and institutions that invest in the buyout funds created by these private-equity firms. And chances are, you'd have to be a big investor to be allocated shares in the IPOs of these private-equity firms. To be sure, if you're a mutual fund investor, your fund may be in on a private-equity IPO. But the funds themselves won't divulge this information until after the fact.
Is there a way for individuals to invest in these funds after their IPOs?
Of course. After the initial public offering, shares of publicly traded private-equity firms will be bought and sold on stock exchanges like any other equity. Of course, this means that you will have to pay the market price for those stocks. So if there's a decent run-up in a private-equity firm's shares on the day of its IPO, you may have to pay a premium for the stock.
Recently, an exchange-traded fund was launched that in turn invests in a basket of publicly traded private-equity firms. It's called the PowerShares Listed Private Equity Portfolio. This ETF invests in public private-equity firms that are in the Red Rocks Capital Listed Private Equity Index. Stocks include such names as Fortress Investment Group, Apollo Investment Corp., and KKR Financial Holdings.
This ETF is less than a year old, so there's not much of a track record–and so far, the fund's performance hasn't been great. Between January 1 and July 11, this ETF has returned 3.6 percent, which is about 4.5 percentage points less than the rise in the S&P 500.
Is there an indirect way to benefit from the private-equity boom?
Yes; you might consider investing in a traditional value-oriented stock mutual fund. Private-equity firms are interested in many of the same companies that value funds target–in other words, overlooked or beaten-down companies that are worth more than the stock market currently values them at. And as more private-equity firms take these companies private, they are buying out the stock at a premium to their trading price, which benefits value-minded funds that already own those companies.