Private equity's barbarians are on top - for now
Flush with cash, private-equity firms are going on a spending spree. But odds are it won't end well.
By Adam Lashinsky, Fortune senior writer

(Fortune Magazine) -- Not since the late 1980s has the world of private equity so entranced Wall Street. The deals are huge ($33 billion for hospital chain HCA), and the investment dollars continue to pour in (new record: Blackstone closed a $15.6 billion fund in July). Lost in the hoopla, however, are the unmistakable signs of a top - signs that have industry insiders plenty worried.

One neon-red flag was the recent decision of Wilbur Ross, a savvy market timer who has called turns in basic commodities like coal and steel, to sell his own firm, W.L. Ross & Co., to Amvescap for $375 million. Ross, who will continue to manage the firm, says he's delighted to have a deep-pocketed new partner and denies trying to time the private-equity market.

Big funds, big deals
Eight of the ten biggest U.S. private-equity deals have been proposed since 2005. Here are the top five this year.
Announced July 24 $32.7 billion. It's the largest offer of all time, but the board will hear other bids until mid-September.
Kinder Morgan
Announced May 29 $26.5 billion. Skyrocketing gas prices have made Kinder's pipelines very valuable assets.
Closed June 2 $17.4 billion. Its new owners have already shut 100 of the grocer's 600 stores.
Announced June 27 $13.6 billion. Rival Televisa, originally outbid, is mulling a higher offer.
Announced May 1 $7.7 billion. The stadium food vendor's shareholders want more from the CEO-led buyout offer.
Sidebar rankings by DEALOGIC

But in the next breath he acknowledges that it certainly does feel like a top and offers up a "worrisome data point": One large European lender says the multiples of the private-equity deals in its portfolio are 50% higher than five years ago.

Buyout funds raised a staggering $131 billion last year, double the total in 2004, and are on pace to exceed that figure this year. But success in raking it in is followed naturally by an urgent need to put it to work - and that's where the trouble starts.

Cyclical returns

"Historically, this looks a lot like 1987 and 1998," says Steven Kaplan, a professor at the University of Chicago's Graduate School of Business who studies private equity and venture capital. Buyout firms suffered tepid returns on the investments they made in those years.

Today, Kaplan says, "the industry is coming off a period of excellent performance, which is typically when a lot of money flows into private equity-which historically is followed by poor returns."

Buyout veterans-while denying their own vulnerability, of course-point to the industry's increasing pack mentality as an area of concern. Not only do private-equity firms tend to invest over and over in the same kind of deal - mattress makers, yellow-pages directories, and private education companies have been all the rage - but they're working now with more partners, a phenomenon known as a "club deal." (The seven firms that banded together to buy SunGard Data Systems last year for $11.7 billion set an informal record.)

Sharing deals in this way ostensibly spreads out the risk. Yet the mutual reinforcement of group buying can also increase the likelihood of overpaying. ("If KKR, Blackstone, and Carlyle all think it's a fair price ...")

But perhaps it is the rising brazenness of private-equity ventures that seems most troublesome. Look no further than the poor public-market performance of Burger King (Charts). Its former private-equity owners at Bain Capital, Goldman Sachs, and Texas Pacific Group paid themselves plenty for "fixing" the burger chain (including a $367 million "special dividend").

But the stock is down 20% from its IPO price in May. And its first-quarter earnings results (which included a $30 million "breakup fee" and a $33 million "make whole" payment to the buyout firms) disappointed investors with lackluster sales.

Predicting a market top, needless to say, is always fraught with danger. And there are some signs of restraint. In the late '80s, deals were often structured so that annual interest expenses on the debt and the amount of free cash flow a company generated were about equal-like spending one's entire after-tax income on mortgage payments.

Today, says KKR partner Marc Lipschultz, interest coverage is usually a much more manageable two-to-one ratio or higher. And those private-equity dollars have a wider canvas on which to play: Once largely a U.S. phenomenon, the buyout business has undeniably gone global. All the major firms have opened offices in Europe. Asia is next.

One player who figures to win no matter how things shake out is Ross, whose specialty is buying distressed properties - an art that would benefit from a private-equity meltdown. While snapping up failing firms requires relatively less capital, Ross points out that the bigger the initial deals, "the more distressed capital you need." Ah, the joys of capitalism. No matter how bad it gets, someone will always profit.

Reporter associates Telis Demos and Anastasia Serdyukova contributed to this article.


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