Blackstone IPO Is a Must-Miss

OK, so maybe this is a bad deal for investors and an example of Wall Street greed at its worst, but stocks have survived overvalued IPOs and huge payouts to insiders before with hardly a ripple. Why is this deal an indicator of tough times ahead for stocks?

Because the very smart guys at the Blackstone Group who are doing this deal see the handwriting on the wall. The success of buyout funds like theirs has been built on cheap debt. Cheap debt has made it possible for the Blackstone Group and other private-equity managers to buy TRW's(TRW Quote) auto parts business, to buy Hertz(HTZ Quote), to buy Burger King(BKC Quote). Cheap debt has made it possible for these private-equity funds to pay themselves big dividends on their investments in these companies, before taking them public, by having the newly private company borrow to fund the payout.

And cheap debt has made it possible for these investors to leverage a modest equity investment in these deals by borrowing most of the purchase price, so that they can then reap returns of 30%, 50% or even 100% when they sell the acquired company back to the public markets.

Nothing Lasts Forever

But this game is coming to an end. Not so much because interest rates in general are rising -- they aren't -- but because interest rates for the riskiest of leveraged buyouts have started to rise. For example, TRW Automotive Holdings, a Blackstone buyout in 2003 that's now public again, recently paid 7.25% on an issue of $1.5 billion in bonds. Still cheap debt, yes, but more expensive than the 6.875% that investment bankers had predicted.

The smart buyout money can also see debt getting expensive in other ways. For example, bankers and insurance companies, who even in this day quaintly like to write covenants into their loan agreements to protect themselves from potential default, have been willing to buy debt in buyout fund deals with very few covenants because defaults rates have been so low.

But with higher default rates visible on the horizon, bankers and other debt purchasers have started to ask for more restrictions on the use of funds from these borrowings and on leverage ratios at the purchased company. That's not an attractive trend from the point of view of a buyout fund manager.

Equity, the kind of money you raise by selling stock to the public, starts to look relatively attractive in this situation. The money is a permanent "loan," since it never has to be paid back to investors who buy the stock. And it comes without covenants or restrictions of any kind. Companies can use the proceeds for any "legitimate" corporate purpose, including paying dividends to buyout fund investors, for example.

Debt and Equity

You could say equity is making a (so-far modest) comeback, after years of taking a back seat to debt.

That isn't great news for equity investors. Share prices have been propped up by debt during recent stages of this rally. Debt has funded corporate buybacks of shares, and those buybacks have made specific stocks look more attractive (fewer shares outstanding means higher earnings per share, since the earnings get spread over fewer shares) and supported the stock market in general by reducing the supply of shares and adding to earnings growth. Debt has funded dividends.

Yes, I know dividends are supposed to come out of earnings, but recently many companies have discovered that it's easier to simply borrow the money in order to pay it out to investors. In that way, too, debt has supported stock prices by making dividend growth look better.

Consider the IPO of the Blackstone Group an early indicator of the shift away from cheap debt. Where Blackstone has gone, other buyout funds will follow, so you can expect to see a steady stream of IPOs from Blackstone's competitors. In my opinion, each deal is just another bit of evidence that the era of cheap debt is moving toward a close.

At the time of publication, Jim Jubak did not own or control shares of any of the equities mentioned in this column. He did not own short positions in any stock mentioned in this column.