The potential dangers that threaten individual investors who do get it wrong are exemplified in a series of trans­actions that began in December 2005, when three private equity firms banded together to purchase the car-rental chain Hertz from Ford Motor Co. Clayton Dubilier & Rice, the Carlyle Group and Merrill Lynch Global Private Equity paid approximately $15 billion for Hertz, including nearly $4.4 billion in cash and $10.1 billion in refinanced, or assumed, debt.

But rather than employing the traditional Private Equity strategy of restructuring the company over the course of several years and refloating it on the stock market, the LBO consortium sucked out $1 billion of its original equity investment in the company in June 2006 via a leveraged recapitalization. Then, in one of the fastest private equity disposals on record, it floated the indebted company on the stock market 11 months after purchasing it.

The firms planned to sell about one-quarter of Hertz’s equity at between $16 and $18 per share. But the market showed little enthusiasm, suspecting that the LBO shops had overleveraged the company and were going to sell the remainder of their equity on the NYSE at the first opportuni

TOP VIEW Individual investors raced into private equity at record levels in 2006. But some experts warn that the leveraged buyout sector, which comprised more than half of all private equity dollars raised last year, is overextended and poised for a correction. Smart investors are adapting their strategies to mitigate the danger. They are looking beyond buyout firms that focus exclusively on loading an acquired company with leverage, and seek fund strategies that help companies grow through strategic acquisitions or operational improvements. Some investors are going even further by developing their own techniques that promise to deliver performance akin to private equity, but with greater control.

ty. The IPO fell short at $15 per share, for a total of $1.3 billion.

Debacles like the Hertz deal have Staglin and many Private Equity investors like him approaching this market with increased caution. They will not eschew private equity altogether, but are instead adapting their strategies to mitigate their risks and take advantage of opportunities presented by this changing sector. These investors are increasing their scrutiny of fund managers when conducting due diligence, but perhaps most important, savvy investors are taking extra care to align their interests with their investment strategy. To this end, they are looking beyond buyout firms that focus exclusively on loading an acquired company with leverage, and seek fund strategies that help companies grow through strategic acquisitions or operational improvements. Some investors are going even further by developing their own techniques that promise to deliver performance akin to private equity, but with greater control.

Meanwhile, capital continues to pour into Private Equity—due in no small part to the dearth of other attractive asset classes. In 2006 (through December 21), private equity firms in the U.S. had raised almost $200 billion, a 24 percent increase over 2005, according to industry newsletter Dow Jones Private Equity Analyst. By the end of last year, these firms, which offer not only buyout funds, but also venture capital, mezzanine funds and funds of funds, had surpassed the record $177.9 billion raised in the last private equity high point in 2000. Buyout funds accounted for more than half of the money flowing into the private equity market.

Returns to Sender
Investors pouring money into these funds have come to expect gains that run well into the double digits. Private equity funds returned an average of 22.5 percent for the 12-month period ending June 30, 2006, beating the S&P 500 by 15.9 percentage points and Nasdaq by 16.9 percentage points, according to Thomson Financial/National Venture Capital Association figures. (Between 1986 and 2006, the average private equity fund, taking into account all investment strategies, had an average annualized return of 14.2 percent.) Debate among investors in 2007 will revolve around whether even the best leveraged buyout funds can continue this run.

As the Hertz deal shows, high rates of return for private equity–backed LBOs depend heavily on the confluence of extremely favorable conditions. LBO shops need new deals with attractive valuations. But increased demand has inflated valuations, forcing buyout firms to pay an estimated average of eight times cash flow in 2006, up from six or seven times in 2005, according to Greg Peterson, a partner with PricewaterhouseCoopers Transaction Services.

Higher acquisition multiples depress overall private equity returns. Last fall, Chris Lewis, general partner with Riordan, Lewis & Haden, a private equity firm in Los Angeles, back-tested his firm’s average annualized 30 percent returns over the past 25 years as if its portfolio companies had cost 1.5 times what they actually had. The analysis showed that paying the hypothetical price decreased their portfolio returns by a few percentage points. “Whenever you have more dollars devoted in the marketplace, the market will do less well,” he says. “We do see it as a constant cycle.”

The market has vulnerabilities other than rising acquisition prices. These include its dependence on very cheap credit, concerns over consortia deals in general and the question of exit strategies.

LBO shops require easy access to more cheap debt to buy companies at these higher valuations. But a reversal in the credit market could quickly eliminate the leverage on which these firms rely. LBO firms generally look for targets with relatively strong cash flows to support their large debt burdens. But a recessionary trend in the overall economy could strangle the cash flow on which these firms depend to service their debt.

Meanwhile, as the size of LBOs has increased, more private equity firms have banded together to bid in groups in order to pool their resources to acquire ever-larger targets. These firms structure collaborative bids because most LBO funds restrict the amount of capital that they can devote to any one investment, to ensure that there is some degree of diversification in their portfolios. Last fall, the Department of Justice launched an inquiry into allegations that these deals were actually collusions that reduced competition and artificially lowered prices paid to the shareholders in LBO target companies.

Private equity principals say they are not worried that the DOJ probe will hurt or transform their businesses. But investors in private equity funds have cause to worry about the club deals nonetheless. Those who have carefully diversified their private equity investments across a number of funds and managers could find their investment stake in a deal unexpectedly magnified should several of their private equity funds participate in the same buyout.

Rush to the Exits
In the long term, the main issue is whether LBO firms will be able to liquidate their holdings and return capital to investors. Massive fundraising, higher valuations and deeper debt demand perfectly timed exits. Today’s multibillion-dollar deals will require huge IPOs or sales to other private equity firms—totaling in the hundreds of billions of dollars—in the next five to seven years. Already the number of private equity–sponsored IPOs has doubled since 2000; 87 deals valued at $21 billion were priced through November 2006, up from 44 at $10.7 billion six years ago, according to Dealogic, a research firm based in London. Nine of the 10 largest buyouts, ranging from $13 billion to $36 billion, were announced in the past year and a half.

Steven Kaplan, a finance professor at the University of Chicago Graduate School of Business, sees a “perfect storm” in private equity investing. “There’s a lot of supply of capital, and lots of demand of it, and a strong economy, and those are all the characteristics that lead to lots of transactions,” he says. In a study published in the Journal of Finance in 2005, Kaplan found that buyout funds lagged behind the Standard & Poor’s 500 for funds raised between 1980 and 1996.

An uncertain liquidity endgame could leave private equity firms and their investors without a viable exit strategy. For investors, an iffy IPO market could force them to hold portfolio companies longer than they had planned, forcing down returns. From the time of Hertz’s IPO until Worth went to press, Hertz shares rose roughly 10 percent. But the private equity firms that retain approximately three-quarters of the company’s outstanding shares must wait to float more shares until the market for Hertz’s stock gains enough confidence and momentum to withstand the pressure of a secondary offering.

Also, while the equity analysts at Wall Street’s largest brokerage houses are nearly unanimous in their view that the stock market’s late-2006 rally will continue through this year, many economists predict a sharp downturn in GDP in the second half, which would weigh on the market and make short-term disposals difficult, while raising the cost of debt and restricting the ability of overleveraged companies to service their loans.

Survival Strategies
Over the course of Staglin’s 35 years investing in private equity, he has sought an operational edge and greater influence by managing his own money. In the past, he served as chairman and CEO of Safelite Glass. Today he holds no CEO title, but plays an active role as a director in some of the portfolio companies in which he invests through FTVentures. The San Francisco–based financial firm focuses on business services and software. “I won’t invest in something unless I believe I have some kind of operational or industry experience,” Staglin says.

Brian Cobb, president and principal shareholder of CobbCorp, a media merger and acquisition company operating out of Naples, Fla., and New York, says that he can afford to take on greater risk when he has greater operational control, and will invest more aggressively when he does. As Cobb has watched banks provide more and more leverage to finance deals at levels starting to exceed seven times cash flow in the past year, he has set a personal limit. He prefers to put in more capital to finance a deal rather than cross the seven-times threshold. “You have to discipline yourself,” he says. “If you take the money and you miss your projections or you miss your numbers then you’ll get disciplined in the most unfortunate way: You’ll lose your money.”

Backers of AEA Investors private equity business also insist on greater control. When the Rockefeller, Mellon, Warburg and Harriman families founded AEA almost 40 years ago, they helped create today’s diverse private equity industry. At the time, however, their plan seemed simple: bring together like-minded investors to buy private companies. For decades, AEA ran its business on the basis of trusted relationships. When readying to launch a new fund, the chairman would call participants and tell them, “It’s time,” recalls Sanford Krieger, general counsel and managing director with the New York–based firm.

In 2003, however, AEA, which focuses on mid-market industrial, chemical and consumer products companies, sought additional funding to broaden its reach. Now AEA’s limited partners demand the kind of legal constraints becoming common in private equity today to address what some consider the primary challenge: mitigating management risk. In fact, a 2004 survey by the Tuck School of Business at Dartmouth found that most investors spend more time placing legal restrictions on general partners. Some limited partners require adjustments in their favor should their private equity funds lose key managers; such defections, of course, often portend diminished returns. These “key-person” events could include the loss of a fund’s star manager or management team, or fraudulent activity committed by an individual or team. Investors’ recourse includes suspending additional investment, reducing the general partners’ profit, cutting short the fund’s term or even closing it.

Krieger contends that too much investor interference can lead to new problems. “If you create an adversarial relationship, there’s a risk that limited partners will look for key-person events,” he says. Instead, AEA favors a no-fault divorce clause to address such events. After a predetermined period (such as two or three years), a supermajority vote of limited partners can end the investment period and liquidate the fund’s assets.

John Hession paid the price when the star general partner of the technology venture capital fund he invested in quit. The partner left to launch his own firm after developing a strong record and reputation for identifying technology start-ups with promise. Soon thereafter, Hession, a partner with McDermott, Will & Emery’s corporate and private equity and emerging companies practice in Boston, watched the remaining venture capital partners change their investment focus and choose biotech companies for the first time in the fund’s life. His fears that returns would suffer from inexperience in an unfamiliar sector proved well founded when performance dipped to single digits. “I was getting passbook savings–like returns,” Hession says.

Hession, who estimates his stake in venture capital funds at 20 percent of his assets, now regrets devoting so much of his capital to one sector. His experience represents the central challenge investors like him face: They invest in a firm’s talents and principals, yet abdicate control.

Alternative Realities
The safest hedge against private equity blowouts may be in keeping a well-diversified portfolio. Nick Vidnovic, director of private equity for Mellon’s Private Wealth Management Group in Pittsburgh, does not place bets on what sectors will surge. Instead, he recommends a large exposure to venture capital along with a weighting in midsize buyout strategies. “We’re not trying to make a call on ‘Now’s the time to jump in with both feet,’” Vidnovic says.

Marc Stern, chief investment officer with Bessemer Trust in New York, advises diversifying across private equity firms as well as strategies. Stern looks for a mix of 15 to 18 managers; this way, no single manager’s poor performance has an inordinate effect, he says. Investors can protect themselves against losses in any single given year by investing their target allocation to private equity over a five-year stretch.

Martin Sass, meanwhile, awaits the downturn. Today’s overheated private equity market reminds him of the late 1980s, when liberal bank lending and cheap interest rates helped fuel a leveraged buyout bonanza. Sass, CEO of the New York–based M.D. Sass Group, which has $9 billion in assets under management, believes the market is primed for a correction. “There’s a flood of money pushing valuations up in both the public and private markets,” he says. “It will affect the undisciplined.”

But Sass sees opportunity in the coming chaos. He plans to raise a new fund in the next year or two, timed to coincide with when he believes default rates will double or triple. He launched a similar distressed securities fund in 1989 following a period of surges in high-yield bond financing and market excesses. He sees similar patterns today, and intends to gather $500 million for his fourth distressed securities fund, Resurgence IV. The downturn, he says, will be “scary if you’re a victim, but will also present opportunities. Although,” he adds, “I’m not ghoulishly eager for a collapse.”

Sass predicts a surge in bankruptcies over the next five years, with groups of intelligent investors capitalizing on the defaults. “When you can buy a company at 10 cents on the dollar of what the LBO was done at—a 90 percent discount—and you know how to operate the company, deliver an overleveraged balance sheet and get the right operators in there, you can have a tremendous upside opportunity,” he explains. 

Elizabeth Harris is a staff writer for Worth.
Illustration by C. J. Burton.

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