Quick Take: Moody's Gets Moody About Private Equity

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When buyout deals like those involving Hilton (NYSE: HLT), First Data (NYSE: FDC), and TXU (NYSE: TXU) are announced, we hear all about the private equity investors in on the purchase. But these firms typically provide just 10% to 20% of the financing. The rest of the money comes from debt sources. According to a report this week, Stock Advisor selection Moody's (NYSE: MCO) thinks there are some serious problems brewing there.

Moody's is one of the world's largest credit ratings services, covering roughly 12,000 corporate issuers, so its opinion holds a lot of weight.

Why is Moody's concerned? The firm is challenging the key value proposition of private equity firms: restructuring companies. Moody's believes that private equity firms are primarily focused on achieving quick flips -- buying, then selling relatively quickly. Doing so generally involves paying large dividends during the first year of the buyout, which requires piling on more debt. Moody's says this was the case in Blackstone Group's (NYSE: BX) deal for Celanese (NYSE: CE).

Indeed, it stretches credulity to think that these dividends help any company's long-term prospects, though it's easy to see how they enhance private equity firms' returns. In some cases, these firms get their whole investment back in these dividend payouts.

Moody's also points out that private equity is benefiting from the cheap rates on debt, along with liberally structured "covenant-light" debt. Both factors make it fairly easy to pay down liabilities and boost returns even further.

Let's face it -- a private equity firm is designed to generate competitive returns for its investors, not to improve Corporate America. That's not to imply that private equity is a menace, but it does help bring some realism to the debate.

Further publicly available Foolishness:

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Fool contributor Tom Taulli, author of The Complete M&A Handbook, does not own shares mentioned in this article. He is currently ranked 2,478 out of more than 60,000 residents of the CAPS investor universe. We'd love to have you join us. The Fool's disclosure policy is out of this world.