EDITORIAL: LOOK HARD BEFORE LEAPING INTO LBOS

The insatiable hunger for bigger and bigger yields has turned leveraged buyout funds into a hot investment entree. But investors should be careful, lest they suffer heartburn — or worse.

As InvestmentNews reporter Anna Robaton wrote last week, leveraged buyouts are no longer a plaything of institutions or the super-rich. Following changes in federal law that expand the number of investors eligible to buy into private partnerships, nearly two dozen firms are marketing to the merely affluent (or soon plan to roll out) funds of funds that invest in LBOs and other ventures.

Some of these funds of funds have lowered their minimum investments to $250,000. And the money is pouring in as fast as they can count it. About $5.5 billion flowed into 18 funds of funds in the first half, up an astounding 83% from $3 billion at 13 funds during the year-earlier period.

LBOs can be risky stuff. (That’s why some buyout funds can boast spectacular 100%-plus internal rates of returns.) But do all these first-timers know just how risky? Probably not.

If things go wrong — and things will go wrong, in many of these deals — you can bet there will be investors itching to sue the financial planners who didn’t stop them from putting their money into these vehicles.

A reminder of the some of the risks:

* Forget liquidity. Many LBOs require investors to wait up to 10 years before attempting to cash out. A lot can happen in a decade. Look back to 1988: Remember Michael Dukakis? Wang Computers? The Berlin Wall? Blackened catfish? Now, imagine not being able to touch your $250,000 between then and now.

* Beware too much money chasing too few deals. Some LBO managers say they are buying safer, putting up 30% equity compared to only 7% in the late 1980s. But let’s be real: The money flowing into LBOs has become a deluge. Institutional assets committed to alternative investments have more than doubled since 1992, to $91 billion from $36 billion, while more than half of those assets have moved into LBO funds, up from 41%. Human nature suggests the percentage of dumb investments won’t be falling anytime soon.

* Trust us, Mr. and Mrs. Investor. There’s no standard way of calculating those impressive internal rates of return touted by buyout funds and funds of funds. And since most of these vehicles are private limited partnerships, they aren’t required to register with the Securities and Exchange Commission.

* Fees, fees, fees. Buyout funds typically charge a 2% annual administrative fee, then take a 20% share of profits after investors get a certain return (usually 5% to 8%). Even as fund managers report having trouble finding good deals in which to invest, they keep collecting that 2% while they look.

* Is it even worth the bother? The top 25% of buyout funds last year saw a 33.7% internal rate of return, vs. 33.4% for the S&P 500 stock index. That’s just 0.3 percentage points more than what an index fund would have delivered. To some people, a good night’s sleep would demand a wider gap.

Yes, LBOs and other alternative investments offer a chance to diversify, which can pay off when stock markets tumble. And a careful investor can make a killing.

But be skeptical, lest that irresistible LBO gobble up your future.