Merrill Lynch ( MER) can't get enough of private equity. The Wall Street firm's big plunge into the leveraged-buyout world has been paying off nicely and is a big reason the broker's fourth-quarter earnings soared by 68% to $2.3 billion. And the Wall Street firm is promising to dive into even more private equity deals in the coming year. But investors better hope that Merrill CEO Stan O'Neal doesn't bite off more than he can chew. It's always easy to sink money into a buyout. The trickier part is finding a profitable exit strategy, especially as buyouts are getting bigger and bigger. So far, Merrill has had great success with one of its earliest private equity deals, a $748 million investment in the 2005 LBO of rental-car giant Hertz ( HTZ). To date, Merrill has already made back most of the money it put into that buyout and stands to make even more in the coming months, in the wake of Hertz's $1.32 billion IPO in November. The big success Merrill scored with Hertz is no doubt tempting it to take on even bigger private equity bets. Last year, it was a player in one of the biggest LBOs of all time, the $33 billion buyout of hospital operator HCA. It is part of the group that wants to purchase Reader's Digest ( RDA) in a $2.4 billion deal.
Merrill executives, in discussing the firm's fourth-quarter results during a conference call, made it clear they are still on the prowl for even more deals. "Our investment banking business continues to make great strides," says Jeff Edwards, Merrill's CFO. "This reflects the strides we have made with the financial sponsors client segment as well as our role in M&A and private equity transactions. We have added substantially to our headcount of high-quality investment bankers over the past several years. We fully expect this group to deliver more growth in the year ahead." The firm, as a practice, does not not disclose its total investments in private equity. Yet Merrill executives say the figure has been growing "exponentially." "It's gone up from essentially a zero number just a few years ago," Edwards says. "While revenues from private equity will continue to be variable, we believe we can continue to grow this business over the long term -- particularly as we engage our growing force of investment bankers in sourcing opportunities." Edwards says that so far this year, it's "already off to a strong start." The firm took a $350 million investment through its private equity arm in the Bermuda reinsurance company, Aeolus Re, at the start of the year. But Merrill's conviction that it can reap huge rewards from all its private equity bets is starting to worry some observers.
It's not often that an LBO is turned around in less than a year into an initial public offering, which is what happened with the Hertz deal. Moreover, Merrill and the other private equity buyers in the Hertz deal were able to push through a $1 billion pre-IPO financing deal to pay themselves a special dividend. By the time Hertz was coming public, Merrill had already made back nearly half of its investment. At that point, it didn't matter much that shares of the car rental chain priced below their expected range. "We are somewhat concerned that the private equity gains and associated banking fees windfall that Merrill experienced in fourth quarter 2006 will be challenging to repeat and slower to develop in future quarters, though we are impressed with its ability to identify high quality investments so quickly in its dive back into private equity," writes William Tanona, an analyst at Goldman Sachs. "Today's results crystallize the firm commitment to risking higher levels of firm capital to generate returns."