COMMENT
Beware The Buyout Bubble

By David Kuo (TMFDragon)
March 13, 2006

Apax Partners, Blackstone and Carlyle are just three names that cropped up when I did a quick trawl of private equity firms that have recently made the news. Apax has been linked with a £300m bid for House of Fraser (LSE: HOF), Blackstone has agreed to buy Center Parcs (LSE: CPK), and Carlyle made four times its initial investment after bringing QinetiQ (LSE: QQ.) to market.

It seems that hardly a week goes by now without one private equity firm or another making the headlines. Only this week there has been speculation that specialist venture capitalist may be planning an audacious £100bn bid for Vodafone Group (LSE: VOD). And last month there was talk that private equity groups have been studying a £25bn takeover of BT Group (LSE: BT.A).

Even by private equity standards these will be quite hefty deals given that two years ago the total value of all such deals across the world was around £100bn. But it seems that the appetite of private equity groups has grown considerably since the technology fallout of 2000. It is estimated that over two thousand private equity funds are raising about £300bn to invest. And given that private equity firms like to supplement every pound of investors' money with £4 of debt, this could imply that over a trillion pounds worth of deals may be waiting to be done.

Historically, private equity firms have channelled money into worthy ventures in what the European Venture Capital Association describes as a "virtuous financing cycle". What happens is that institutional investors such as pension funds, banks and insurance companies provide the bulk of the funding to start, grow and revitalise businesses. By and large, two of their bets would fail, six would be marginally profitable and just a couple will triumph. Nevertheless, the brace of winners more than compensated for the underperforming investments.

But it seems that the rules have changed as previously unknown private equity firms compete fiercely for finance. For instance, very few UK investors had ever heard of Singapore's Temasek before its daring bid for P&O. So, in order to generate decent returns, private equity firms are now turning to much larger bets to satisfy the hunger of their investors, in particular pension funds that are facing gaping pension deficits.

It is hard to say if we are close to the top of the private equity buyout cycle. Interest rates are still quite low, which means that private equity firms are still able to augment their deals with cheap loans. Additionally, pension funds still need to look beyond listed shares for lucrative alternative investments to close their pension gaps.

But a shortage of cheap, acquirable assets may point to faltering returns for private equity funds. That is unless they go back to doing what they are supposed to -- provide risk capital for business and improve operationally inefficient businesses rather laden good businesses with heaps of debt. Unfortunately, a desire for quick returns suggests that private equity firm will continue to follow the path of least resistance, which means more horse-trading than horse-sense.

> What Venture Capitalists Do | Become A Venture Capitalist