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December 22, 2006

Could The Market Be Too Bullish Regarding The Impact of Private Equity?

There is no doubt that flood of money into private equity funds and the subsequent investment of these funds in buyouts of public corporations has contributed greatly to the 2006 bull market. Conventional wisdom is that private equity buyouts of public companies will continue at its recent pace, providing support to current public equity valuations despite the big increase in valuation multiples this year.

That is why I found this Reuters article so interesting. The theme is that private equity funds may run short of investor dollars because they are not exiting enough deals and returning funds to current investors. Reuters states that the value of private equity backed buyouts is over $600 billion this year but exits are only $177 billion. Furthermore, several major buyout firms including Carlyle, Warburg Pincus, and Blackstone are all trying to raise additional funds in the $5 to $10 billion range.

The article identifies two issues that could lead to a shortfall in funds raised by private equity, which means a shortfall in funds available for buyouts, at least relative to conventional wisdom. First, many large investors in private equity are at or close to their current allocation limits for private equity. Second, the lack of exits means that private equity firms are going to back potential investors without a track record when asking for more funds....

Even if this thesis proves correct, there are a couple of offsets. Banks and bondholders are willing to accept more and more leverage in recent deals. The $25 billion currently being sought by Carlyle, Blackstone, and Warburg Pincus can be leveraged at 9 to 1 these days compared to 6 to 1 a few years ago. That is an extra $75 billion in buying power. With private equity funds as a group raising a few hundred billion dollars a year recently, the incremental leverage ultimately creates hundreds of billions of additional buying power. Therefore a shortfall of fundraising of $10 to $20 billion might not prove much of an obstacle to the seemingly endless stream of private equity backed takeovers.

Additionally, I don’t see why the lack of track record will slow the flow of investment dollars into funds. At least among the major players, there is enough of a track record, Reuters quotes a 22.5% return in the 12 months ending June 2006, to convince current investors to up their allocations temporarily in anticipation of more exits in the next few years.

Despite my arguments that are sanguine for private equity funds, this article raises some important issues. Any shortfall in the ability of private equity funds to raise funds should set alarm bells ringing in public equity markets given the importance of deal flow to the bullish sentiment. Even more bearish would be a shortfall in available buyout funds at a time when private equity firms are looking to dramatically up their rate of exits. The IPO market is very healthy but the supply-demand balance for public equities would be altered dramatically if private equity buyouts peaked simultaneously with a surge in IPOs.

Reuters says that "The Blackstone Group is having a hard time raising the last chunk" of money for its latest fund. As my friend Doug Kass says, "Makes me say, hmmm."

Posted by Steve Birenberg at December 22, 2006 02:01 PM in Stock Market