Today, this investment phenomenon still excels at delivering strong returns, but the deals are increasingly high profile and, in our opinion, increasingly risky.
"when endless amounts of money chase a finite amount of assets, the price of those assets is bound to go up"
So why the rise of private equity? We put much of the activity down to abundant global liquidity. To get an idea of how this leads to audacious private equity deals, let's follow this river of money downstream, beginning at the source - or more accurately - sources.
Private equity money comes in two forms, debt and equity. We hear a lot about the debt component (and we'll talk about that shortly) but what about the equity, where does that come from?
Just like fund managers, private equity firms manage money on behalf of clients. These clients were traditionally 'high net worth' individuals, but this has now expanded to include pension funds, among others. With the huge amount of dollars flowing into retirement funds around the world, private equity is getting a larger slice of an ever expanding pie.
The upshot of all this is more money burning a hole in the pockets of private equity vehicles. This is why we are seeing so many deals in so many industries. Traditionally, private equity bought into underperforming businesses, engineering a turnaround by replacing management, restructuring operations and/or selling off assets.
However, after a four year bull market, there are less underperformers or 'cheap' stocks to consider. The bull market has allowed companies in general to get their balance sheets in order by paying down debt. And this is an opportunity private equity has seized upon. Instead of buying underperformers, as in the past, the targets are now the 'undergeared' - or those with relatively low levels of debt.
"... the recent private equity frenzy is pushing up the price of assets to levels where there is much risk and little reward."
Most private equity transactions (also known as leveraged buy-outs or LBO's) involve the injection of a fair amount of debt. In a typical deal, at least four dollars of debt combines with every dollar of equity investment. The main point here is that every investment dollar (or dollar of equity) going into a private equity vehicle creates additional demand for assets when combined with high levels of debt funding.
And debt markets have been more than prepared to accommodate this demand. The global banking system thrives on debt issuance. In most cases, after lending funds, banks hedge their risk in the derivatives market. The global derivatives market has grown at a mind boggling rate over the past few years.
According to the Bank for International Settlements, the value of derivatives increased by 24 percent to an astounding $370 trillion in the first half of 2006. "Growth was particularly strong in the credit segment, where the notional amounts of outstanding credit default swaps increased by 46 percent." This apparent hedging of risk encourages banks to continue lending to high risk borrowers such as private equity.
So while there is a seemingly endless source of money, there is only a certain amount of assets to buy. And when endless amounts of money chase a finite amount of assets, the price of those assets is bound to go up.
While all this activity looks like fun and games in the short term, the private equity groups are playing a high risk game. There are two things that private equity firms are relying on to generate strong returns - low interest rates and strong corporate profitability. On the interest rate front, we believe that over the next few years, inflation will raise its ugly head, and interest rates will rise.
Shorter term, however, the private equity players may have some time up their sleeve. This is because the US economy, led by the housing market, is slowing down. A housing induced slowdown removes quite of bit of demand from the global economy, as consumers reduce spending.
Provided the rate of output (supply) continues from China and the rest of Asia, this excess of supply over demand may place temporary downward pressure on prices, and therefore interest rates.
We believe the Federal Reserve would respond to weaker demand by lowering interest rates. Such a response would put the boot into an already shaky dollar, which would ultimately sow the seeds for interest rates to revert higher once again.
The graph below shows bond rates (as measured by the 10-year bond yield) from the 1960s through to today. Day-to-day, interest rates move at glacial speed, but it is evident from the chart that they do indeed move.
After falling for most of the past 20 years, we believe US interest rates bottomed in 2003. While they may not head higher immediately, over the long term, we believe bond yields are on the way up. And higher borrowing costs will remove a great source of funding for the private equity gang.
In the meantime, let's give private equity the benefit of the doubt and assume their borrowing costs are fixed for the next few years. Rising interest rates, therefore, should not pose too much of a problem.
So, with interest rates fixed, the next thing to focus on is corporate profitability. As long as profits remain strong, highly leveraged companies should continue to generate strong returns. However, corporate profitability as a percentage of Gross Domestic Product (GDP) is at the highest level in forty years, rising from about 7 percent in 2001 to more than 12 percent in the first quarter of 2006.
This does not necessarily mean that corporate profits have peaked and are at risk of falling sharply, however it does increase the risk for many highly leveraged companies. Wages, on the other, have been stagnating. Companies have kept a lid on wages over the past few years, but this trend may now be beginning to turn.
If labour costs grow quicker than company revenues, profitability will decline. Falling profits and a highly geared balance sheet tend to have an ugly effect on share prices.
The point of all this is that the recent private equity frenzy is pushing up the price of some assets to levels where there is much risk and little reward. In our opinion, the risk/reward balance is one of the most important factors to focus on. However the great attraction of equity markets of course, is that there's always an opportunity, somewhere.
We would for instance point out that the increasing flood of paper dollars into the system is good news for gold. We continue to see gold as an important hedge against risk in the global financial system, and gold and gold stocks are therefore an important part of any investors' portfolio.
Greg Smith is the Managing Director of Fat Prophets. If you would like a further sample of their expert research please click here.
If you have any questions or inquiries about this article feel free to email info@fatprophets.co.uk or call 0800 389 0705