The Big Deals Wheel Again

By Barbara Kiviat

Toys "R" Us. Dunkin' Donuts. Univision. Hertz. Those are names of well-known American companies. Bain. Carlyle. Texas Pacific. KKR. Those are names of the lesser-known outfits that bought them in the past year and a half. If you thought the New York Stock Exchange was the place to invest, think again.

Private-equity firms pumped up with vast amounts of money are snatching public companies in an unprecedented buyout wave. In an updated, renamed version of the leveraged buyout, or LBO, private-equity firms acquire undervalued companies, load them with debt, overhaul operations and then return them to the stock exchanges whence they came in ballyhooed IPOs--collecting fees at every turn. Fever pitch officially took hold last week when hospital chain HCA was taken private by its management, founder and three buyout firms in a record deal worth more than $30 billion.

The amount of money flowing into such deals is off the charts--nearly $198 billion so far this year, including debt, compared with $118 billion for 2005 and $96 billion for 2004, according to Thomson Financial. Flush with cash from investors seeking better-than-market returns, buyout firms are looking for places to spend the $70 billion raised so far this year, not to mention the $130 billion from last year. And they can borrow as much as $10 for every $1 they invest, meaning there aren't many companies out of reach. Says Mark Nunnelly, managing director of Bain Capital, one of the firms in the HCA deal: "Private equity is here to stay as an important player."

The last time we were in a place even roughly comparable was the late 1980s, the decade that birthed LBOs, so called because firms got a lot of their buying power from debt, or leverage--particularly high-yield, risky junk bonds. Raiders feasted on bloated conglomerates such as Beatrice, buying them up, busting them apart and reselling at a profit--until the economy slipped into recession. The ensuing bankruptcies killed off the junk-bond market, and the deals dried up. The late 1990s saw a tech-driven LBO resurgence, but that too ended with the 2000 bubble burst.

Now the buyout firms are back, and there are more of them. The new boom is being fed by low interest rates, a no-go stock market and banks eager to lend. CEOs are more willing to listen since stepped-up regulation and a focus on short-term performance has taken some of the allure out of running a publicly traded company.

But most important, demand from investors has skyrocketed, especially from pension funds, which means you might be invested in a buyout fund and not even know it. The long-term outlooks and multibillion-dollar purses of institutional investors have always made them a match for buyout funds, which lock up money for five to 10 years, promising a high return in exchange. These days, there's even more interest because "alternative investments," which also include hedge funds, are all the rage. Pension funds that used to invest, say, 2% of assets in those vehicles now go up to 10%, and smaller funds that used to steer clear of buyouts are jumping in.

The reason? Hot results. According to Thomson Financial and the National Venture Capital Association, buyout funds returned 31.3% last year, scorching the 6.3% for the Standard & Poor's 500. Over time, though, buyout funds haven't provided the same premium. The annualized return for buyout funds over the past 20 years was 13.3%, compared with 11.0% for the S&P.

Investors also like the industry's new Establishment cred. The old model of buying an overstaffed, underleveraged company, stripping it of cash and slashing jobs and expenses simply doesn't work as well now that corporate America has learned to downsize itself. Competition from abroad keeps companies on their toes just as well as the threat of a hostile takeover ever did. "The heart and soul has become real business building," says Marc Lipschultz, a partner at Kohlberg Kravis Roberts (KKR).

True, but that doesn't preclude job cuts, nor does it mean that "financial engineering" is gone. When Hertz filed for an IPO in mid-July, it was up-front about why it needed the cash: to service debt that helped pay a $1 billion dividend to the outfits that had bought it less than a year before--Carlyle Group, Clayton Dubilier & Rice and Merrill Lynch Global Private Equity.

The action is attracting a host of new players. Investment banks, which retrenched after the tech bust, are ratcheting back up, as are money managers like financial-services firm Amvescap, which last week acquired WL Ross & Co., a buyout firm run by turnaround specialist Wilbur Ross. Even hedge funds--whose trader mentality is antithetical to buying and holding--are taking pages out of the buyout playbook. Hedge-fund operator Eddie Lampert not only bought and merged Sears and Kmart but also installed himself as chairman.

That sort of competition is pushing up the price of deals and extending the chase to Europe and Asia. It's also prompting firms to buy companies they would have spurned just a few years ago. Retail--a highly competitive sector with low margins--is a case in point, says Christopher Kampe, director at Grant Thornton Corporate Finance. In the past year, Linens 'n Things, Burlington Coat Factory, Petco and the Sports Authority have all been bought.

History says that when too much money chases the same asset class, things end badly. As the bids go higher and the deals get thinner, private companies carry ever greater debt. Four years ago, 41% of the payment for the average buyout came from equity and the rest from debt. Today the average equity level is down to 35%, according to S&P. That is still a far cry from the 7% equity levels of the original buyout craze, but the trend is nonetheless an indicator that the industry is starting to overheat. "That often happens toward the end of one of these cycles," says Ross. "People get too aggressive with their lending."

Default rates are at a superlow 1%, but buyout specialists expect them to move back toward their traditional 5%. As that happens, the gains that investors thought they had locked in may start to slide. In the late 1980s, "people were euphoric about how private equity was going to become the dominant form of investment," says David Yermack, a professor of finance at New York University. "All those predictions turned out to be spectacularly wrong. That will be the case now as well." Last month, however, Blackstone Group announced it had raised $15.6 billion, a record for a buyout fund--and a sign that it's not yet midnight at the predators' ball.

With reporting by Kathleen Kingsbury/New York