The Economist on the private equity boom

Private equity

Glory days
Aug 4th 2005 | NEW YORK
From The Economist print edition

Buy-outs are booming. Why?

THESE are heady days in the world of big buy-outs. Investors’ money is flooding in, swelling private-equity funds to record sizes. Recently the Blackstone Group, a blue-chip private-equity firm based in New York, raised a $12.5 billion fund, the biggest ever.

Deals are getting bigger, too. In late May, an eclectic group of European and American investors including Wilbur Ross, a buy-out specialist, said that they planned to buy 63% of Wind Telecomunicazioni, an Italian telecoms firm, for more than $12 billion. If they do, the deal will trump the purchase announced in March of SunGard Data Systems, an information-services company, for $11.3 billion. And that, in turn, was the biggest buy-out since RJR Nabisco went for $25 billion in 1989.

How different it looked a decade ago. Internet stocks were booming and buy-outs–the business of snapping up undervalued companies, often using big dollops of debt, and selling them later for big profits–seemed old and tired compared with their sexier and more profitable venture-capital counterparts. Then hedge funds stole the limelight after the technology bubble burst. Because these funds can go short as well as long, they posted positive returns even as stockmarkets slumped.

But buy-outs are back. According to Private Equity Intelligence (PEI), a research firm in London, buy-out funds worldwide have raised $81 billion this year through early August, up from $60 billion over the same period in 2004. And they have invested an incredible $233 billion (see chart)–38% more than a year earlier, according to Dealogic, another research firm.

Underlying the boom are several trends. Borrowing costs are low, so private-equity firms have financed acquisitions cheaply. Corporate earnings are robust and lenders desperate for business, so private-equity owners are borrowing still more against firms’ growing cashflow. For those buy-out shops that presciently bought undervalued assets in 2002 and 2003, returns today from selling, floating, refinancing or otherwise liquidating earlier investments have been spectacular.

Last year, on figures from PEI, private-equity firms returned a whopping $131 billion in capital to investors, net of contributions. Preliminary figures for the first quarter of this year suggest that the trend continues. On other calculations, buy-out houses in Europe alone paid their shareholders enormous dividends in the first half of this year. Of the record €25 billion-worth of leveraged buy-out financing raised in Europe, more than €12 billion was used to recapitalise existing deals, according to Fitch, a rating agency. Private-equity investors are essentially borrowing to recover their original stakes and then some, while retaining ownership of the companies involved.

This success in cashing out of earlier deals is further feeding the buy-out boom. For one, it is bringing in new investors: New Jersey’s State Investment Council recently decided to give private equity a go, earmarking 5% of its assets to the sector. It is also spurring existing ones to increase their stakes. The huge net flow of cash into their pockets means that pension funds and others must plough more money into private equity just to maintain their “target” private-equity allocations. Many pension funds are happy to do so in hopes that juicier returns from “alternative assets” such as private equity, property and hedge funds will help close their gaping deficits.

So far, so good. But the flood of money brings with it problems. With so much cash chasing similar deals, prices are rising. Competition is especially fierce for the “middle-market” private-equity houses, which compete both with other private-equity firms and with hedge funds.

For the mega-funds such as Blackstone and Carlyle, finding good deals also means finding sizeable ones that are worth their while. Increasingly, big funds are banding together to chase mega-deals. But the supply of attractive, huge deals is finite. And strategic players–generally willing to pay more for deals because of perceived operational synergies–are re-entering the fray.

Most buy-out investors, though, remain sanguine. They argue that opportunities have only increased with time. Back in the 1980s, buy-outs were about financial engineering; today, they allow investors to bet on growth, turnaround situations and, increasingly, the world outside America and Britain. How far will it go? Big buy-out shops are already setting up in India, China and elsewhere. But sharply higher interest rates could put paid to all these plans.

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