Look for the sizzling market for leveraged buyouts to get even hotter in 2007.Private-equity firms spent the past year playing a debt-fueled game of "Can you top this?" They pulled off one huge acquisition after another, unveiling a stunning $21 billion HCA deal in July and going on to gobble up giants like Clear Channel ( CCU) and Harrah's ( HET). Now speculation is building that buyout firms are racing to pull the trigger on the biggest LBO ever, eclipsing the $25 billion bar set nearly two decades ago when Kohlberg Kravis Roberts bought RJR Nabisco. Predictions of a deal worth $50 billion, $75 billion, or even $100 billion have grown commonplace. Though those figures are eye-popping, it's hard to argue with the logic. Private-equity firms took in more than $200 billion in new money from institutional investors in 2006, so buyers' wallets are fat. Meanwhile,
But for now, few on Wall Street are giving any of that a second thought. It's full speed ahead for private-equity managers and their fee-hungry friendly bankers at Bank of America ( BAC), Citigroup ( C), Goldman Sachs ( GS), JPMorgan Chase ( JPM), Lehman Brothers ( LEH), Merrill Lynch ( MER) and Morgan Stanley ( MS). "The banks really have been one of the key facilitators," says Scott Gehsmann, the leader of PricewaterhouseCooper's global capital markets group in North America. "They really are pushing money out the door." Indeed, in December alone, private-equity firms plunked down more than $30 billion for companies ranging from orthopedic device-maker Biomet ( BMET) to real estate broker Realogy ( H). The end-of-year rush of deals comes on the heels of several mega-LBOs in 2006, including the $21.2 billion buyout of hospital operator HCA, the $18.7 billion deal for radio station chain Clear Channel, and a $19 billion bid for Equity Office Properties Trust ( EOP). In a typical LBO, private-equity firms rely on bonds and bank loans to pay for about two-thirds of the acquisition cost. In the best year for corporate mergers since 2000, there's no denying that cash-rich private-equity firms are ruling the roost. Buyout artists at Apollo Management, Bain Capital, Blackstone Group, Carlyle Group, Texas Pacific Group and Thomas H. Lee Partners are leaving their brush marks on every sector, targeting companies in industries as diverse as the media, semiconductor manufacturing, health care and real estate. In fact, the titans of private equity are sounding downright cocky these days. David Rubenstein, co-founder of the Carlyle Group, boasted in a recent interview with the Financial Times that "private equity is perhaps the face of American capitalism."
Looking at the latest statistics, it's easy to understand the pride of Rubenstein and his well-compensated peers, whose private-equity funds typically charge management fees of 2% and keep up to 20% of a fund's profit. In 2006, LBOs, on a dollar basis, have accounted for 27% of the U.S. mergers and acquisitions, according to Dealogic. By comparison, private-equity-backed deals accounted for 14% of all domestic M&A in 2005 and just 10% of U.S. deals in 2002. And of the 10 biggest LBOs in U.S. history -- excluding the value of acquired debt -- eight have occurred in 2006. It's only a matter of days or weeks before Kohlberg Kravis Roberts' massive $25 billion takeover of RJR Nabisco in 1988 is replaced as the biggest-ever LBO ever. If you include the assumed debt, several of this year's LBOs exceed the size of the RJR Nabisco takeover. "If you are sitting on a board of a public company and you get hung up in a business model that takes some unforeseen turn, or get caught behind the eight ball, you will become vulnerable," says Gehsmann. "The wolves just start circling." In the short term, all this LBO activity has been good news for investors in targeted companies, as well as the many rumored to be in buyers' sights. Private-equity firms, on average, are paying a 22% premium in their deals -- the same premium that investors are getting in all U.S. mergers, says Dealogic.
But the trouble could come if the economy starts to slow down and the companies taken private by buyout artists start struggling to service all the debt that's been added to their balance sheets. Right now, bond defaults are low, but that could change in a time of economic duress. So far, private-equity firms have sold some $59 billion in high-yield corporate bonds to finance transactions this year, according to Dealogic. That sum represents about half of the total high-yield notes, or junk bonds, sold by corporations this year. High-yield bonds, of course, carry the greatest risk of a default. In the event of an economic slowdown, private-equity firms might be forced to slash costs at some of these recently acquired companies in order to generate an acceptable rate of return on their investments. That could mean the shuttering of operations, or the closing of stores and offices. That all translates into job losses for the people working at some of the companies being taken private. If that were to occur, today's captains of industry may look like tomorrow's corporate villains -- at least in the eyes of the public and the media. Others also worry that with private-equity firms flush with so much cash and easy access to credit, it's only a matter of time before the buyout crowd overreaches and does some dumb deals. There's already evidence that buyout firms may be biting off more than they can chew.
The $18.7 billion buyout of Clear Channel is raising eyebrows because some doubt there's a lot the private-equity buyers can do to revive the radio station chain, which has seen its stock slide from a high-water mark of nearly $90 a share in 2000 to its current price of just under $36. The golden days of radio are over, with more and more listeners and advertisers gravitating to the Internet and TV. True, revenue remains strong at Clear Channel, which took in $5.15 billion over the first nine months of 2006. But revenue is up just 6% over the same period last year, and revenue growth could slow as the economy cools and advertisers spend less. Over the past nine months, Clear Channel generated operating cash flow of $480 million, also up 6% from a year ago. Private-equity firms tend to target companies with a healthy cash flow, which is the money generated by a business after paying taxes and expenses. To service the $21.5 billion in debt that buyout firms Bain and T.H. Lee are using to finance the transaction -- which also includes $8 billion in assumed debt --Clear Channel's managers will need to generate more revenue or slash expenses in order to produce a higher level of cash flow and fat investment returns. The private-equity buyers doubtless can achieve some of that by selling off radio stations and other assets. But at the end of the day, they aren't taking on a high-growth enterprise. Then again, private-equity firms, which once held on to their investments for an average of five years, increasingly are looking for a quick exit strategy. It's become all too common for buyout firms to either resell their takeovers or put them up for an IPO within a year or two of the buyout. And before they do that, the private-equity firms are paying themselves handsome dividends, usually financed by an extra layer of debt. So with the LBO crowd adopting a short-term investment horizon, buyout-artists need not worry too much how the companies they acquire today will perform over the long term. They'll be long gone by the time some of these businesses falter, and will leave the job of cleaning up the mess to others.