Why Private Equity Is Through the Roof
This article is from the archive of The New York Sun before the launch of its new website in 2022. The Sun has neither altered nor updated such articles but will seek to correct any errors, mis-categorizations or other problems introduced during transfer.

Private equity deals are getting bigger and bolder, but are they becoming less profitable? Aren’t the firms simply overwhelmed by inflows of funds, and consequently throwing money at deals?
Such questions have occurred to many as they watched the private equity players gobble up ever-larger businesses. According to Dealogic, private equity bids in America alone have already topped $360 billion this year — more than double the 2005 full-year total of $163 billion. Moreover, 10 of the 12 largest-ever purchases have occurred in the past 18 months, and there’s no end in sight. Just before Thanksgiving, the Blackstone Group made headlines with its $36 billion offer for Sam Zell’s Equity Office Properties Trust — the largest buyout offer ever.
For those who have followed Mr. Zell’s career, this was not reassuring. Although he has on one or two occasions been too early to enter or to leave a market, Mr. Zell has overall proved a brilliant prognosticator of real estate values. The deal highlighted all the concerns swirling about this unstoppable industry.
Thus it was enlightening to hear from one of the Big Players in the private equity realm the other day. Without agreeing to be identified for this article, he provided an extremely cogent explanation of the logic behind the private equity express, and so we pass it on here.
First, every deal needs a willing seller as well as a willing buyer. The Big Player argues that CEOs of public companies today are keen to take their companies private. They are tired of dealing with Sarbox, including the excruciating 404 requirements, the oppressive legal commitments, and the resulting deterioration in board relationships. Because directors are now invested with unprecedented legal responsibilities that include oversight of the CEO, the board relationship is often strained and occasionally antagonistic. No wonder the average time served by CEOs has gone down steadily, to about five years.
CEOs are also being harassed incessantly about excessive compensation. They often stand to make substantially more money working for a private equity outfit.
The CEO’s malaise is compounded by a measurement system that is totally at odds with reasonable management decision-making. The CEO can’t make important long-term decisions for fear of mucking with quarterly earnings. Heaven forbid he misses the analysts’ estimates and skewers the stock price.
Further interfering with sensible management has been the elimination of the all-purpose “extraordinary items”that used to clutter corporate income statements. These accounting footnotes allowed companies to divest businesses while protecting operating income from the resulting charges for personnel layoffs and such.
Nowadays, companies spend a great deal of time trying to match the onetime costs of such beneficial pruning with offsetting gains, so that those precious quarterly results appear intact. The result is that managements are often choosing to postpone necessary restructuring moves.
The BP says that almost every time his team meets with the management of a public company, the CEO can list several things he would like to be able to do for his company, but that he is unable to do because of the short-term consequences. That’s not good for anyone.
Overall, the CEOs of most companies are willing sellers. What about the buy side?
Until recently, market valuations have been favorable for private equity shops. The S &P 500 is selling at 17 times earnings, but multiples were considerably lower only recently. These levels compare favorably with other buyout booms, and offer private equity investors plenty of opportunities.
Low acquisition prices have led to above-average performance numbers, which are attracting rising allocations from pension fund managers. In the case of the BP’s firm, for instance, returns on average have been 13% ahead of the S&P 500.
Another feature of the financial landscape that has facilitated these transactions is the extraordinarily low spreads in the debt markets. The differential between the best credits and the worst is unusually compressed. Investors are basically not acknowledging risk, which says a good deal about the health of the economy. Credit defaults are at all-time lows, promoting an unusual sense of well-being among lenders. The BP said his firm recently concluded a deal in which there were no covenants — a rare statement of faith.
Why aren’t corporations also taking advantage of these low valuations and readily available credit to buy up other companies? Many are, but the advantage held by private equity firms is that they can use more leverage. Financing from the CLO and the structured finance market is cheap and plentiful, fueling many transactions. Overall, the BP says, the private equity firms have a lower cost of capital.
Now the toughest question: Are the deals still profitable even with the move up in equity markets? The BP says they are, in part because of the advantages conferred by size. By having portfolios of dozens of companies, management can exact group pricing on commonly used goods and services. Insurance, transportation, and health care costs are just a few areas in which volume discounts can make a difference in the bottom line. Thus, size does matter, and returns are enhanced.
When does the party end? If stock prices continue to go up, attractive deals will become scarcer. Recent advances have pushed many transactions onto the sidelines already. Also, a recession would inevitably lead to rising defaults, and a restructuring of credit markets. Spreads would widen, making financing more costly.
Until then, the party goes on.