Highfields Capital is the latest market Cassandra to warn of a growing leveraged-buyout bubble. The $8 billion hedge fund has been cleaning up on some recent private equity-sponsored takeovers. But in a recent letter to investors, the Boston-based outfit says the record sum of money being raised by buyout firms shows institutional investors foolishly "chasing returns in the rearview mirror." Private equity added to its buying binge Thursday with a $19 billion takeout of radio conglomerate Clear Channel ( CCU) by Bain Capital and Thomas H. Lee Partners, and a $1.6 billion buyout of Reader's Digest ( RDA) by Ripplewood. The Clear Channel deal was particularly good news for Highfields, which more than doubled its position in the Texas broadcaster's stock during the summer. Highfields held 11.1 million shares as of Sept. 30. The hedge fund, which often targets companies it perceives as undervalued and ripe for a takeover, bought nearly 6 million of those shares when the stock was trading between $27 and $29 a share -- well below the $37.60 takeout price. Highfields is up more than 15% for the year, thanks in no small part to the buyout crowd. The hedge fund says some of its well-timed and "significant" investments include Michael Stores ( MIK), Aramark ( RMK) and Harrah's Entertainment ( HET), each of which has seen shares soar after fielding a buyout offer.
"We think the risk/reward is far superior owning the shares at their current valuations than being forced to pay a 25%-30% control premium," writes Highfields management in its third-quarter investor update. "We are glad the private equity firms recognize the value that we did and are willing to pay more for it." Officials with Highfields, led by Jonathan Jacobson and Richard Grubman, did not return a phone call seeking comment on the investor letter. Looking down the road, Highfields says the biggest winners from the current LBO craze won't be the pension funds and university endowments giving their money to the buyout crowd. Rather, the ones laughing all the way to the bank will be the well-compensated managers who run the private equity firms. "It is hard to fathom how paying a control premium well in excess of the public market price and layering on management and incentive fees can yield anything other than mediocre (or perhaps worse) returns absent a huge increase in the ability to exit at a much higher multiple," the firm wrote. "Suffice it to say that the megabillion-dollar private equity funds of 2006 will likely turn out to be much better for their general partners" than for their limited partners. Private equity firms typically charge management fees of 1% to 2% and can skim off up to 20% of the profit a fund generates from its investments. That's a compensation formula similar to one employed by hedge fund managers.
Highfields is not alone in sounding a cautionary note about the burgeoning role private equity firms are playing on Wall Street. Just last week, Barton Biggs, the former Morgan Stanley ( MS) market strategist,
said "investors in private equity have excessive expectations" and warned about the fallout from the bursting of the current buyout bubble. Additionally, the British Financial Services Authority recently raised concern about all the debt that private equity firms are adding to the balance sheets of companies they take private. The British said that it could come back to haunt the markets when the economy sours. There's no denying that private equity-backed buyouts are on a tear. To date, the dollar value of leveraged buyouts now accounts for a whopping 26% of all U.S. mergers this year, according to Dealogic. In all, buyout firms have paid $320 billion to take out U.S. companies. Last year at this time, private equity firms had spent $149 billion on LBOs. It's not just the growing use of leverage in financing these deals that's raising concern. Others are beginning to complain that LBO firms are looking to cash out of their investments too quickly and not spending enough time improving the operating efficiency at the companies they target. In the past, private equity firms typically held onto an investment for several years before looking to cash out. But now, private equity firms are paying themselves hefty dividends and looking to cash out just months after taking over a company.
A case in point is Hertz ( HTZ), the giant rental car company that a group of private equity firms took public this week, less than a year after buying it from Ford in a deal valued at $15 billion. A big reason the IPO fell flat was the widespread perception that the private equity firms behind the deal had done nothing but fleece the New Jersey-based company by taking a $1 billion special dividend. Hertz is getting none of the $1.32 billion raised by the offering. All of the proceeds will go toward paying another special dividend to the private equity consortium and to paying down a loan that financed the initial dividend. It's worth noting that the private equity firms behind the deal -- Merrill Lynch ( MER), Carlyle Group and Clayton Dubilier -- sank just $2.3 billion of their own money into the buyout. The rest of the deal was funded by debt added to Hertz's balance sheet. But savvy hedge funds like Highfields see that debt as an opportunity -- regardless of whether it may spell trouble for the broader market. In the investor letter, the fund notes that while the capital markets currently are friendly to borrowers, at "some point, this will change and create another cycle for distressed debt."