We've all been forced to show up at events we'd rather not attend, such as your spouse's best friend's birthday party or your in-laws' for the holidays. And you know the scene: The moment you arrive you're trying to figure out how to get out of there.
That's exactly how the private-equity players think when they buy a new company. "It's all about the exit," says Dennis Barsky, a private-equity partner at New York-based law firm Jones Day.
The "exit" equates to a big financial payout. Granted, they just need to turn the company around and bring the company back to the market, either through an initial public offering or a sale to another company. But they have their eyes on the prize the whole time.
And for many in private equity, we're not talking about hitting the daily double on Jeopardy. This is real big money. Like early retirement on a yacht in the Caymans kind of big money.
Although private-equity firms have been around for years, they've been making quite a din on Wall Street recently. That may be because after everyone and their brother wanted to go public in the late 1990s, the trend has flipped. Now going private seems to be the in thing to do.
"In the last two years, the money raised by private-equity firms has far exceeded the most recent boom in 2000," according to Liz Ann Sonders, chief investment strategist at Charles Schwab. "This has been fueled by ample credit and by a flood of giant capital investments from many of the world's largest and most powerful pension funds."
And 2007 is expected to be just as hot.
In fact, it already is. Just this week, two Australian companies,
were rumored to be working on separate $40 billion offers to acquire Alcoa
. And last week,
Four Seasons Hotels
agreed to a $3.8 billion buyout deal from a group led by its chief executive.
And there's more to come. Wall Street speculates that companies like
might be taken private as well.
But can this boom last? How do shareholders fare in these deals? And why would a company want to go private in the first place? Those were just some of the questions that you asked, so the Booyah Breakdown is going to answer them now!
When a company's board of directors decides to put itself up for sale, it doesn't necessarily seek out private-equity firms.
The board's sole responsibility is to get shareholders the best deal. "So whether another public company buys them or a private-equity firm comes in, the bottom line is getting shareholders the most value," says Barsky.
But thanks to a successful track record and a recent influx of cash from pension and endowment funds, private-equity firms, such as Warburg Pincus, Blackstone Group and Kohlberg Kravis Roberts, have money to burn. So they can afford to pay top dollar.
But don't think they spend all their money on these deals. When a company is taken private, the majority of the deal is "leveraged." That means the private equity firm borrows most of the money from the bank. On a $1 billion deal, for example, it's not uncommon for the firm to finance just $700,000 of it.
And with interest rates so low these days, firms can borrow much more money than in the past. "As long as the debt markets are still open, the pace should continue," says Dave MacKinnon, a transactions advisory services partner at Ernst & Young in New York.
Let Freedom Ring
There are some clear perks to taking an ailing company private. The biggest is freedom, says Sonders.
When a company is private, it doesn't have to answer to Wall Street or to the whim of impatient investors. That means no more scrambling to get earnings-per-share or EBIDTA (earnings before interest, deprecation, tax and amortization) numbers in line with analysts' estimates.
It also means no more dealing with a nagging board of directors. A private company's board is made up of people who also have their eyes on the prize.
Additionally, the dreaded Sarbanes-Oxley is no longer a thorn in their sides, and they can focus on increasing cash flow and running the business. Of course, private companies are still audited because they need audited financials to show the banks, notes Barsky. But that's considerably less pressure than quarterly reports and analyst conference calls.
And then, of course, there's also the pay scale. A private company can pay its people whatever it wants, without having to explain themselves to the public. Public companies have to let analysts rip their compensation plans to shreds. Remember Michael Ovitz and the shareholder outrage over his $140 million severance after working barely more than a year at Disney?
So because of all this, private-equity firms can keep and retain top-quality people who just need to focus on cash flow and strengthen the core business, says Barsky.
So How Do You Trade on Privacy?
Many of you were concerned about losing shares in a company you liked once it was taken private.
But ask yourself two questions. First, is your payout from the deal better than your original purchase price, a.k.a. cost basis? Second, is the business in need of transformational change? If you answered "yes" to both questions, then you should be happy to take the money, says MacKinnon. Otherwise, if the company is struggling, you risk losing money on your investment.
Now don't go nutty trying to pick the next buyout deal. The average premium paid over market prices for shares of acquired companies in 2006 was 17%, down from 25% in 2000, according to Thomson Financial. Still a good payout, but clearly falling. And with the economy (supposedly) slowing, there is some risk of these firms defaulting on all those loans. So the returns could start to slip.
Just tread cautiously.
And as an aside, pay attention to the supply of stock in the market. The private-equity boom is actually contributing to its decline. "Combined with cash acquisitions, record-breaking stock buybacks, and no better-than-average initial public offerings, the supply drain has been substantial," says Sonders.
So you need to keep your eye on the prize too. Just because investing in a private-equity firm's next hot takeover target sounds exciting doesn't mean it should be your exit strategy too.
Tracy Byrnes is an award-winning writer specializing in tax and accounting issues. As a freelancer, she has written columns for wsj.com and the New York Post and her work has appeared in SmartMoney and on CBS MarketWatch. Prior to freelancing, she spent four years as a senior writer for TheStreet.com. Before that, she was an accountant with Ernst & Young. She has a B.A. in English and economics from Lehigh University and an M.B.A. in accounting from Rutgers University. Byrnes appreciates your feedback;
to send her an email.