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Private illusions

The buyout business is booming once again, but do investors know what they're getting with all that leverage?

The leveraged buyout industry has never been bigger or bolder. Over the past year private equity has raised and spent record amounts. It has generated fabulous returns for investors. Nevertheless, private equity feels unloved. The leading buyout barons are taking time off from deal making to argue their case. The industry is also setting up a trade association, the Private Equity Council. Yet no amount of PR can conceal that the buyout industry is a fee-hogging, asset-gathering operation that generates returns primarily by leveraging assets.

The case for private equity begins with mouthwatering returns. In the three years to mid-2006, the average annualized return after fees for buyout investors was 26 percent, according to investment consulting firm Cambridge Associates. Where do these returns come from? Well, says the buyout apologist, private equity managers know a thing or two about adding value. By taking control of the whole company, they claim to have gotten rid of the so-called "agency problem," the numerous issues that arise when the management and ownership of public companies are separated. Private equity owners have a longer time horizon than stock market investors and are more willing to make hard decisions to create value, continues the apologist. The high interest payments of leveraged buyout firms reduce their tax bills, giving them a lower cost of capital. In a recent report on the industry, the U.K.'s Financial Services Authority concluded that "private equity offers a compelling business model with significant potential to enhance the efficiency of companies. . . . This has the potential to deliver substantial rewards both for the companies' owners and for the economy as a whole."

Or not. The case against private equity also begins with investment returns. For a start, the gains from private equity are very unevenly distributed. Unless investors have money in the best-performing buyout funds, they're likely to be disappointed. Then, as with hedge funds, there's a problem of survivorship bias in the data -- the returns of the successful private equity firms are recorded in the performance data while poor funds drop out.

Although some private equity deals undoubtedly add value with turnarounds and mergers ("roll-ups" in industry parlance) of their companies, there is no evidence that this holds true in aggregate. On the contrary, research by Cambridge Associates finds that average private equity returns can be surpassed by adding leverage to an index of listed companies. In November, Darren Brooks, a Citigroup strategist in London writing in the firm's European Portfolio Strategist report, pointed out that over the past ten years, investors could have beaten the returns of the best private equity funds simply by applying private-equity-style leverage to a portfolio of quoted midcap value stocks.

Although private equity does away with of the ancient division between ownership and management of public companies, it brings a host of new agency problems. Buyout firms have interests that are distinct from those of their investors. Private equity firms make a one-off fee of about 1 percent for each deal. They also extract annual management fees of 1 percent after the acquisition and take a profit share, normally 20 percent above a hurdle rate, when a company is sold. Given these facts, we might expect profit-maximizing private equity firms to do the following: Grow assets under management as quickly as possible, invest that money speedily and look for the first opportunity to exit.

Recent behavior conforms to this pattern. Buyout firms are raising unprecedented sums, nearly $240 billion in 2006, according to London-based consulting firm Private Equity Intelligence. Several leading firms now manage funds in excess of $10 billion -- Blackstone Group even has a $20 billion fund.

With profits bloated by a long period of expansion and the stock market at record highs, you might think private equity firms would have slowed their rate of spending by late 2006. Not so. Over the past year several of the megafunds, including those run by Blackstone and Bain Capital, have spent more than half of their huge piles within months of raising the money. This frenzied activity belies the claim that private equity acts like a value investor waiting patiently to invest at the right price. Because buyout firms are putting the money to work so speedily, their limited partners are more exposed than before to the danger of buying in at a cyclical top. Furthermore, rising competition has pushed up valuation multiples for buyouts. That spells lower future returns.

The buyout frenzy is also leading to some questionable deals. For instance, in April, Blackstone spent E2.7 billion ($3.3 billion) for 4.5 percent of the shares in listed German telecommunications company Deutsche Telekom. This stake gave Blackstone board representation but no management control. Private equity is entering into sectors traditionally considered too risky to carry large amounts of debt. Of the $17.6 billion acquisition of Freescale Semiconductor in September, Fred Hickey, editor of the monthly newsletter "High Tech Strategist" observed: "Hugely cyclical, often money-losing, and usually cash-burning semis have all the attributes that should make LBO funds steer clear." The tax advantage of buyouts was conspicuously absent in 2006's largest deal -- Blackstone's $36 billion purchase of Equity Office Properties Trust, whose status as a real estate investment trust exempted it from corporation tax.

Then there's the unseemly dash to the exit. An early sale or large dividend (or "recap") allows private equity firms to boost reported returns. High returns help attract more assets for new buyout funds. Today companies are handed from one firm to another, sometimes as often as three or four times in succession. Buyout shops also look to float their companies as soon as possible on the stock exchange. Hertz Global Holdings' IPO, for instance, occurred less than a year after the December 2005 buyout. Speedy disposals suggest that private equity is not relying on its vaunted turnaround skills to generate returns.

Private equity involves a sleight of hand. Companies are taken from the public market, where the investment risk is evident in the daily fluctuation of share prices, and transferred to opaque buyout funds, where the risk is enhanced by leverage but concealed from public view. Hiding the true risk serves private equity because it makes buyout returns appear less volatile. It's no wonder that the industry has been fighting a change in accounting rules that forces firms to mark their investments to market.

Because large institutional investors have stakes in both the stock market and private equity, the investor base may not change dramatically after a buyout. Yet investors are paying huge fees for this public-to-private "repackaging" service. Many private equity deals amount to little more than piling on debt. The Modigliani-Miller theorem teaches that adding debt to a company doesn't add value (leaving taxes aside). By employing leverage, risk and returns rise in tandem. Investors, it seems, are suffering from a "private equity illusion."

Buyouts have generated large returns in recent years. But this has been because of the combination of very strong profit growth and a rise in corporate valuations since the stock market bottomed out in 2002. Extraordinarily loose credit conditions have also played an important role. Private equity firms have been able to finance risky deals at very low interest rates. Easy money has also supported rising debt levels (relative to operating cash flow) and higher purchase prices for buyouts. According to Citi investment banker Michael Klein, writing in November in a report titled "The Private Equity Revolution," average debt to earnings before interest, taxes, depreciation and amortization has climbed to 5.6 times from 4.0 times in 2004. This trend has facilitated dividend recaps and private equity's daisy chain of corporate sales.

When the good times end, the cyclicality of private equity's "excess" returns will be exposed. But it won't be just buyout investors who suffer. The banking system has a large and increasing exposure to leveraged buyouts. Although the great majority of these loans are parceled out in a matter of months, if the buyout party stops abruptly, some banks will surely be caught on the hook. Then there is the legacy of excessive corporate debt to consider. This could cripple hundreds of companies in years to come. Jon Moulton, founder and managing partner of U.K. private equity firm Alchemy Partners, has recently warned of the prospect of rising defaults and a corporate world filled with "headless chickens." Institutions, whether insurance companies or pension funds, that have invested in buyout debt or in private equity funds, are also at risk.

Indeed, the only major financial players who stand to profit from a buyout bust are the private equity firms themselves. Senior industry officials admit in private to looking forward to a downturn so they can acquire companies at more-attractive valuations. Several firms, including industry titans Blackstone, Carlyle Group, Kohlberg Kravis Roberts & Co. and Texas Pacific Group, have anticipated such an outcome by raising distressed-debt funds. Wall Street has witnessed a good deal of cynicism over the past couple of hundred years. But nothing quite matches this.