Private equity is not, nor has it been, in the midst of a bubble. Its recent boom-times have been driven by legitimate market factors, and risk has been so mitigated – via debt securitization, among other techniques – that today’s private equiteers are unlikely to suffer the same fate as venture capitalists circa 2001. But, that said, I distinctly hear to dulcet tones of a plus-sized female, and they are growing louder.
Conventional wisdom has been that the private equity boom will eventually be curtailed by one of two happenings: (1) A series of mega-deal collapses based on fundamental misjudgments or; (2) A major bank loan squeeze. Some also have suggested a stock market collapse, but I’d argue that such a scenario would simply result in an LBO volume increase, with private equity firms gorging on under-valued assets while waiting for the public cycle to eventually return to the upswing.
None of the above has yet come to pass, of course, which is why most everyone is predicting that 2007 will top the deal-making records set in 2006. I believe I even did so just a few weeks back. But there is a clear and present danger presenting itself: LBO firms have become so successful – and so public about it – that sellers and alternate strategic buyers no longer believe initial LBO bids are adequate.
For example, imagine that Primack Corp. is trading at $10 per share, and The Blackstone Group offers to buy it out at $12.50 per share. That’s a traditional 25% premium, but Primack Corp. shareholders are worried that they’re being taken for a ride: “If Blackstone thinks it can make a major profit at $12.50, then the offer is clearly too low…” Ditto for possible strategic acquirers: “If Blackstone is willing to pay $12.50 just as a financial play, then perhaps we should bid $14 per share and make up the difference in consolidation value…”
In just the past few months, we’ve seen: the Harrah’s board force a major price raise, Fidelity Investments signal its intention to oppose the Clear Channel sale, Blackstone get topped for Equity Office and Carlyle engage in a stunning game of one-upmanship for Elkcorp. And these are just the ones that come to mind while I’m rushing to meet deadline.
All of this matters, particularly because the shareholders and strategic buyers are wrong. Private equity IRR expectations are not rising exponentially, despite popular belief. In fact, they have been declining as deals get richer. If sellers and strategics continue to force the prices higher – which they will – it simply must result in an end to the boom. Either firms will smartly slow down their deal-making activity (i.e., only compete where the price makes sense) or will foolishly lower their return expectations to the point where LPs are no longer comfortable with their current role as capital spigots.
So revel in the boom for a little while longer, but also begin girding for the long haul…