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Private Equity and Leveraged Buyouts Affect All Investors
The torrid pace of cash inflows to U.S. private equity funds and the surge in private equity leveraged buyout activity continued to make headlines in 2007. Many of us have read these headlines and wonder – what are they talking about and how does this affect me as an investor? This article will help you understand these headlines and their impact on your investments.
Cash raised by private equity firms has exploded in the last 11 years. In 1995, private equity firms raised $36.1 billion. Cash came in at a record pace of $226.9 billion in 2006, and 2007 likely set another record. Private equity firms raise funds from a variety of sources. These sources are typically public pension funds, corporate pension funds, insurance companies, foundations, endowments, and wealthy individuals.
Private equity firms say they provide superior returns for investors by using non-traditional investments such as leveraged buyouts. Those firms also argue that private-equity strategies are not correlated to public securities markets and are thus a good way to diversify a portfolio.
Much of the flood of cash going into private equity funds has been used to initiate leveraged buyouts of small and mid-size companies. In 2006 there were 128 such deals, which is a dramatic increase in activity from the levels of a few years ago.
A leveraged buyout (LBO) of a publicly-held company is a tactic through which control of the company is acquired by buying up a majority of the company stock. The publicly-held companies targeted for acquisition by private equity firms are typically out-of-favor, under-appreciated companies that would be typical holdings for "value" investors. The stock purchase price offered by private equity firms has been running at a 10%-15% premium to the current stock price of the acquired company. Private equity firms frequently sell parts of the acquired company to recover the cash used to pay for the acquisition, and those firms finance the rest of the acquisition with high-yield debt.
Mutual funds that hold bond investments can be affected by private equity leveraged buyouts. In an LBO the acquired company's high-quality (investment grade) bonds are typically downgraded to high-yield (junk bond) status. Managers of investment-grade bond funds have seen losses when their bond holdings are downgraded in this LBO process. On the other hand, leveraged buyouts of strong businesses with clean balance sheets and few foreseeable liquidity issues have provided good opportunities for high-yield bond fund managers to gain higher returns.
Low interest rates facilitate high returns to private equity investors, because the increased interest expenses after the acquisition may be easily covered by a strong revenue stream, allowing the leveraged company to continue to be profitable. The company could then be sold for a handsome gain by the private equity fund.
Some people are skeptical that LBOs are beneficial to the economy as a whole. The private equity investors are engaging in a relatively risky strategy that could result in economically disruptive losses if interest rates rise to the point that highly leveraged companies become unprofitable.
Portfolio managers of stock mutual funds see adverse effects on long-term fund investors. In essence, the managers believe that many private equity deals are approved at a stock price well below the true value of the acquired company, driven by short-term factors and by an attraction to quick and modest profits. While those investors may receive the 10%-15% "buyout premium" when a private equity firm acquires a company held by a mutual fund, those same investors lose the opportunity for larger gains supported by the company's future operations. The fund no longer owns the company and holds low-yielding cash until the fund can find an attractive investment.
As an example of the pervasiveness of these events, one mutual fund company with three small-cap funds lost 47 different companies to mergers and acquisitions in 2006. A reduction in the number of publicly traded companies restricts a portfolio manager to a smaller set of attractive holdings for his or her fund, and that restriction may tend to reduce future returns for the fund.
Given this information, what is an investor to do? We realize that private equity activity and leveraged buyouts can be confusing and overwhelming topics for many people. At Pleasanton Financial Advisors, we keep abreast of trends in the fast-changing investment landscape. We also learn how specific portfolio managers are thinking and acting in this environment, and we assess manager skills in the context of the current environment. Those parts of our investment process help us choose portfolios with a better-than-average reward-to-risk profile. You may wish to adopt a similar process, or you may delegate those tasks to us as a recipient of our investment-management services.