Beware the Private Equity Bull
There's an old stock market saying that goes The bull market is over when the bull is on the cover of Business Week. Well, private equity was on the cover of the February 27, 2006 issue of Business Week and one might wonder whether that signals the top of that market as well.
Private equity consists of funds devoted to buying businesses with a combination of equity and debt that does not involve public equity markets. Seeking returns higher than those available from publicly traded securities, bonds or other investments, fund managers are buying businesses with the intent of improving company performance and then reselling them (privately or publicly) for vast profits. Management icons like Jack Welsh (former GE CEO) and Lou Gerstner (former IBM CEO) have been enlisted to add luster and help guide the efforts.
Until recently, private equity was largely under the radar. Fifteen years ago there were only a handful of firms managing at least $1 billion; now there are at least 260, reports Business Week. The industry controls $800 billion in capital which is devoted to buying companies.
With so much money seeking to buy companies, the predictable is happening. Prices paid for companies have gone up and the search for companies to buy has spread far, wide and deep, encompassing family businesses of modest size in the pool of potential targets.
Private equity funds claim to be focused on long-term shareholder value. That's true in relation to the quarterly obsessions of Wall Street but private equity's goal focuses on financial engineering, depending not on long-term strategies and cash flow but on deals that produce large profits in periods of five years or less. Partners in private equity funds typically take in a 1.5 percent annual management fee, plus 20 percent of profits when a company is sold or taken public, plus gains on whatever they may have personally invested in their funds.
Driven by the promise of rich rewards (perhaps from greater fools who are willing to pay ever higher prices), deal prices and leverage are skyrocketing, according to Business Week. Some businesses have changed hands north of 20 times earnings before income taxes, depreciation and amortization (EBITDA). By the end of last year, the average private equity deal involved debt of 5.6 times EBITDA, according to Standard & Poor's. Such deals represent a tightrope requiring a strong economy, benign interest rates and perfect management execution to avoid failing.
What does all this mean to family business? Selling under such circumstances can be attractive, especially given the current capital gains tax rates. But should you sell, be careful with your proceeds. Cash is attractive but rates of return for low-risk investments remain low. Reinvesting in other businesses puts you in the continuing bidding frenzy.. Beware looking for greener grass.
Many family businesses are carefully watching private equity for wreckage, for the deals that go awry. Salvaging value that financial operators fail to recognize has long been a strategy of smart, experienced, truly long-term investors.
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