How to Play the End of the Private-Equity Boom

This column was originally published on RealMoney on Mar. 3, 2008 at 3:52 p.m. EDT. It's being republished as a bonus for TheStreet.com readers. For more information about subscribing to RealMoney, please click here.

From 2004 right up until the first two weeks of August 2007, it was widely assumed that there was a private-equity put in the stock market. Any time valuations fell to a certain level, it was just assumed that the funds, flush with cash and the ability to obtain almost unlimited leverage would swoop in and bid the shares back up.

You know what? There was, and I have to confess, I miss it. It was a lot of fun. All you had to do was put together a portfolio of stocks that generated free cash flow , had small amounts of debt and sold for less than five times enterprise value to EBITDA , and you were going to get a lot of takeovers among your stocks.

Simply by paying attention to hedge funds' and other activist investors' 13d filings, you could pretty much see in advance where the private-equity money would show up next and position yourself accordingly.

The End of the Good Old Days

Of course, after August, the game changed, and quickly. First, financing dried up almost entirely. It was no longer possible to put up a few hundred million and borrow several billion to buy companies. There would be no more talk of levering up a company's balance sheet , taking out a special dividend and letting the cash flow pay off the debt for a few years before you took the company public again. Those days were over.

Also, as the economy began to falter, the days of portfolio companies running on autopilot also came to a crashing end. Rather than merely looking for new deals to fuel returns , it became necessary to actually pay attention to companies you already owned. The party was, if not over, a lot more subdued than the glory days.

There was a private-equity conference in Germany this past week, the 11th annual Super Returns Summit. For a conference where the attendees controlled so much money, and their thoughts and attitudes have such a strong affect on stock prices going forward, it was pretty lightly covered by the mainstream business press. Some of the largest private-equity funds were represented, and they had a lot to say about the future of deal-making and where the money would be made, and perhaps more importantly, would not be made in the years ahead.

David Rubenstein, the managing director and founder of Carlyle Group spoke on Wednesday [Feb. 27] and set a somewhat somber tone for the industry. He thought it would be at least 2011 before peak times returned to the private-equity game. He also said it would take a while for leverage to become a part of the buyout process for some time, as banks, stung by being unable to syndicate and sell loans from 2007 leveraged buyouts, were still dealing with losses form those transactions.

He feels that minority stakes in emerging-market companies were going to be a source of private-equity returns over the next few years (see "China: 'The Best Place to Invest in the Next Five to 10 Years'"). He also offered a ray of hope when he pointed out that many of his best-performing previous deals were bought in times of distress. If prices are low enough, he told attendees, you don't necessarily need leverage.

Going After Debt Rather than Equity

Buying in times of distress was a common theme among speakers in Frankfurt this past week. Leon Black of Apollo Management talked about buying up the debt of companies rather than the equity of companies as a source of profits in the next several years. "It is all about value creation," said Black."

You can get equity-like returns from debt instruments that may be a better play than pure equity right now when you cannot get leverage. Ironically, much of the debt he was talking about was from private-equity deals in earlier years that had pushed companies into financial distress when the economy began to slow down this past year.