Like the hedge fund phenomenon that resulted in their proliferation a few years ago, getting in on private equity deal-making is the next big thing in investing. And like the hedge funds that opened their doors to smaller investors, private equity is now making the arena no longer the preserve of large, wealthy individuals. Today, the small retail investor has several options to get in on big private equity transactions. But is that a good thing? Let's take a deeper look at what's happening.
Business development companies (BDCs) have sprouted up to let you invest in the next growth stock. They pair debt or debt-like instruments with an equity stake in a growing company, and just as REITs pass onto shareholders 90% of their taxable income, BDCs offer a similar tax architecture. Because they're structured as regulated investment companies, they trade with substantial dividend yields. American Capital Strategies (NASDAQ:ACAS), for example, pays shareholders a 7.9% dividend, while Allied Capital (NYSE:ALD) has an even higher 8.2% yield.
One of the latest iterations in bringing private equity to the retail investor is the so-called special purpose acquisition company, or SPAC. It's what's known as a "blank check" company. You're investing in an IPO that promises to make an acquisition -- only you don't know what or whom it's going to buy. While that's a bit like buying a pig in a poke, the upside is that as a SPAC shareholder, you get to vote on the deal. If you don't like it, or the deal is not approved by a majority of the shareholders (or more than 20% of the shareholders vote against it), you get your money back. If the SPAC doesn't make a deal within 18 to 24 months, you also get your money back in that case. Consider it a horse race in which you're betting on the jockey.
Freedom Acquisition Holdings (AMEX:FRH) is the largest of the SPACs to go public in recent months. It just today agreed to a reverse merger with GLG Partners. That'll give Freedom shareholders a 28% stake in the company, which will list on the New York Stock Exchange under the symbol GLG. The U.K.-based company, which manages 40 funds with more than $230 billion under management, has something of a checkered relationship with foreign regulators over several instances of insider trading. But that hasn't stopped Freedom's stock from surging 10% today on the news of the reverse merger.
According to Dealogic, 30 SPACs have raised $3.5 billion in IPOs so far this year, outstripping the $3.4 billion raised all of last year by the 40 SPACs that had IPOs. Yet not all SPACs are successful. Merrill Lynch (NYSE:MER) was unable to raise enough money in its planned $125 million SPAC offering last year, and Bank of America (NYSE:BAC) scaled back an IPO from $150 million to $100 million this past December.
But why go through all the hassle and risk of investing in such a circuitous manner? Why not just invest directly in the private equity company itself? For example, Blackstone (NYSE:BX) just went public in a $40 billion IPO, and Kohlberg Kravis Roberts will be launching its own public showing soon.
The boomlet in private equity public offerings -- a seeming oxymoron if there ever was one -- carries great risks that the rashness with which small investors flock to them seemingly overlook. We needn't look at the huge injection of money that Bear Stearns (NYSE:BSC) had to inject into its hedge funds recently to save it, or the crash of Amaranth Advisors from its energy sector plays, to see that there are no sure things. You're also going on blind faith with management at a BDC or SPAC that it will pick the right horse to ride when it makes an acquisition.
As for the private equity IPO frenzy whipping the markets into a froth, that may soon crash on the shoals of easy credit's demise. Cheap money is not so cheap anymore, and with so many dollars chasing deals these days, the price of transactions is getting more expensive. Overpaying for a few too many deals will bring back the haunting days of the 1980s and 1990s, when the leveraged-buyout market imploded. That's probably why the Foolish community is so overwhelmingly bearish on the private equity frenzy.
Boasting that you're involved with the latest private equity mania may make for interesting cocktail party chatter, but the damage it may wreak on your portfolio when -- not if -- the party ends can make even the savviest investor look like a rank amateur.
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Fool contributor Rich Duprey does not have a financial position in any of the stocks mentioned in this article. You can see his holdings here. The Motley Fool has a disclosure policy.
