The Softer Side of Private Equity

Since the famous go-go times for leveraged buyouts (LBOs) in the 1980s, LBO shops have undergone a bit of a PR overhaul. With books like Barbarians at the Gate (and the corresponding made-for-TV movie starring the great James Garner) covering the $25 billion leveraged buyout of RJR Nabisco and painting the industry in a less-than-flattering light, the public began to see the financiers behind these buyout deals as corporate raiders out to get rich at the expense of whoever got in their way. A facelift, or at least some new make-up, was probably in order.

Today, LBO shops have reincarnated themselves under the uber-generic "private equity" moniker and in the past couple of years have started a full frontal assault on the public markets. They have already blown the RJR deal out of the water with the buyout announced for HCA (NYSE: HCA  ) , and it seems as though a couple of new deals are announced every week. Interestingly, though, there is more to the "private equity" header than massive deals and tons of debt.

A brief history
A leveraged buyout is a full buyout of a company by a financial sponsor using a hefty amount of debt to finance the transaction. The basic idea behind a leveraged buyout is that by using debt, as opposed to equity, to finance the transaction, the sponsor can get a much higher return on the equity it does invest. Anyone who owns his or her own home likely has a very intimate idea of why leveraged acquisitions are so great. As homeowners know, if you put down 20% on your home and it goes up 3%, your equity has gone up in value a heck of a lot more than 3%.

In very rough numbers, I laid out a hypothetical acquisition of a company -- MakesNothing Corp. (Ticker: NADA) -- that does $1 billion in revenue and has 10% year-over-year growth. Let's say that Barbarian Capital puts in an offer to take NADA private at 12 times EBITDA. If Barbarian pays for NADA in all equity and manages to resell the company for 12 times EBITDA in five years, it will have earned roughly a 10% annual rate of return on its investment over the five years. However, if it pays for 70% of its acquisition in debt, it can jack up its returns to nearly 30%!

It's these types of attractive returns that led to Jerome Kohlberg Jr. first pioneering the idea of an LBO back in the 1960s. His firm, Kohlberg Kravis Roberts (KKR), formed with partners Henry Kravis and George Roberts, made what many believe was the first LBO back in 1964, when it bought out Orkin Exterminating Company. LBOs didn't get really big until the 1980s, when the public debt markets became more robust. The defining moment of the '80s LBO rush was the aforementioned, much-publicized RJR acquisition by KKR.

Today, along with big daddy KKR (which has completed more than $200 billion worth of transactions at this point), there are investment banks like Goldman Sachs (NYSE: GS  ) that dabble in buyouts, as well as dedicated firms like Bain Capital, Blackstone Group, Thomas H. Lee Partners (a.k.a. "Tommy Lee"), and Silver Lake Partners. These players have more money than ever, and with the headlines as evidence, they're not afraid to use it.

The other side of the tracks
But multibillion-dollar take-private transactions are not the only face of private equity. In fact, if you take the 50,000-foot view on what "private equity" means, it's really any managed pool of capital used for investing in private companies. So, in addition to LBO funds, this would also include venture capitalists and growth investors. And it's actually the growth investors who were most often thought of as "private equity" until the LBO guys wanted a new image.

As opposed to LBO funds, which use a lot of debt and look for slower-growth companies with high cash flow, or venture capitalists, who invest at the very early stage, growth investment funds primarily invest equity capital and look for profitable, growing, privately held businesses. The companies they invest in are past the venture capital start-up stage but are still growing quickly and have a long runway ahead of them. Similar to the LBO guys, growth investors generally target an exit from the investment four to six years down the road through either an IPO or a merger.

It's likely that you've never heard of the a lot of the names in this realm of private equity -- names like General Atlantic, GTCR, Insight Venture Partners, Spectrum Equity Investors, Summit Partners, and TA Associates. But it's very likely that you have heard of some of the companies that have come to the public markets from these funds. DivX, which is up more than 50% since going public in September, was from the portfolio of Insight. Hittite Microwave, a former Summit portfolio company, is up more than 80% since its IPO in 2005. And after a big 10% move yesterday, the TA investment InterContinental Exchange is up a whopping 146% since its debut a year ago.

Don't go chasing waterfalls
So why bring up this group of investors that typically fly under the radar and invest in private companies? It's simple -- because the businesses they bring to the market still have some juice left in them; they're still businesses on the come.

I look at a company like Hertz Global Holdings (which is being brought public from the portfolio of Carlyle, Merrill Lynch's (NYSE: MER  ) private equity fund, and Clayton, Dubilier, & Rice), and I am just not all that impressed. Sure, it's a well-known company, but it will probably have to break its back to keep up a 10% top-line growth rate and, as of the most recent S-1 filing, it has a daunting $14 billion of debt weighing it down. Because Hertz has nice cash flow, the debt isn't going to put it out of business, but overall it's just really not that exciting of a story.

On the other hand, Clayton Holdings (Nasdaq: CLAY  ) , which went public from TA back in March, came to market sporting a profitable bottom line, a compounded annual revenue growth rate of more than 50%, and a lot of potential growth ahead of it. And while the housing market has kept a lid on Clayton so far, Bare Escentuals (Nasdaq: BARE  ) , which came out of the stable of Berkshire Partners and JH Partners, has jumped nearly 20% since its IPO. Like Clayton, Bare came out of the starting gate very profitable and touting a nearly 60% sales CAGR in the three years before the IPO. Will NYMEX (NYSE: NMX  ) -- which is making a public market debut this week with a fat 43% pretax margin and a 30% sales CAGR since 2001 -- make the bull run that many are expecting? I can't predict that, but I can say for sure that this was a company that General Atlantic invested in. And, yes, that's the same General Atlantic that was an investor in NYSE Group (NYSE: NYX  ) .

My point here is that there's a lot of ruckus around the moves that the LBO big boys are making. Everyone wants to figure out what the next big buyout is going to be so they can take that sweet, sweet acquisition premium home. But why try to make blind guesses at that when you can follow proven great investors and hop on a train at the beginning, rather than the end, of the road? So next time you want some fare with a little of that risky flavor in there, instead of trying to figure out where KKR is going to strike next, take a look at the "Principal Stockholders" section of a few IPO prospectuses and invest with some big-money guys.

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In a previous life, in a far-off universe, Fool contributor Matt Koppenheffer worked for a private equity growth investor. Today his life is less private equity and more Howard Stern's Private Parts -- and that's A-OK. Matt owns shares of Goldman Sachs. The Fool'sdisclosure policyis never a private matter.


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