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.