Private-equity craze could batter investors

The flood of money into leveraged buyout and private-equity funds reportedly has driven down the returns of…

The flood of money into leveraged buyout and
private-equity funds reportedly has driven down the returns of many of those funds as too much money chases too few good deals. But it appears to have helped investors in the broad market.
That’s good news for investors in the short run but maybe not in the long run.
According to an analysis by The Leuthold Group, a research and mutual fund company in Minneapolis, the shrinkage in the supply of equities available on the open market caused by private-equity groups’ taking companies private, mergers and acquisitions, and stock buybacks has pushed returns on the Standard & Poor’s 500 stock index up.
The Leuthold Group analysts, analyzing Federal Reserve flow of funds data back to 1952, found that in quarters when net equity issuance is negative, the S&P 500 return is 2 percentage points higher than in quarters when the issuance is positive.
The net issuance of corporate equities has been negative for the past eight quarters (through December 2006). Though final figures for 2006 are not yet available, for the first three quarters of the year, net issuance was declining at an annual rate in excess of $400 billion. And the pace of the reduction increased during the year. The annualized rate of decline in the first quarter was $395.1 billion; in the second quarter, $467 billion; in the third quarter, $565.9 billion.
In 2005, there was a net decline in shares outstanding of $153 billion.
The decline in the supply of equities is good news in the short term for investors because it has boosted returns and because those investors whose companies have been taken private, or acquired by another company, generally have received a significant premium for their shares.
And it may be good for the economy if all of those companies privatized indeed are run more efficiently once their executives no longer have to worry about Wall Street’s reaction to quarterly earnings reports. But it could be bad news in the long run, for several reasons.
First, most private-equity funds eventually expect to return their acquisitions to the public markets. That’s the exit strategy.
Their plan is: Take a company private, shake up the management and slash employment, and hopefully make it more efficient. Often they leverage up the balance sheet, saying the company was using too little debt.
Sometimes the private-equity group sells one or more operating units, using the proceeds to pay down the debt and sometimes to reward the general partners. Then after a few years, they take the company public again at a higher price than they paid for it and repay the investors.
That means there could be a flood of new issues down the road, and the increase in supply might hold down returns at that time, just as the reduction in supply is adding to returns today.
Of greater concern is that the increased leverage of the privatized companies could become an unbearable burden if the economy should enter a significant recession. Some of the privatized companies could be forced into bankruptcy, and so too could some of those which have been taken public again.
Borrowing by the business sector increased again in 2004 and 2005 after declining during the 2001-2002 recession, and increased at an annualized rate of $669.8 billion in the third quarter of last year, according to the Federal Reserve flow of funds report.
Not all of the companies privatized will become more efficient. Some merely will look that way because of financial engineering or because costs have been cut drastically. In some cases, those costs will have cut into the company’s muscle and bone, and will damage the operations in the long run.
Sometimes companies can be so lean they can’t manage crises — just ask David Needleman, chief executive of discount carrier JetBlue Airways Corp., who learned that lesson in the snows and ice storm two weeks ago which resulted in a quagmire of scheduling delays.
All investors, those in private-equity funds and those not, had better hope the economy can avoid a financial storm until the current private-equity storm runs out of steam, and the privatized and newly public companies pay down some of their debt.