Foolish Forum: Private Equity Fever

Private equity has been making the headlines almost as much as Britney Spears and global warming combined. Here to chat about the private equity frenzy -- and what it means for investors -- is Matt Koppenheffer, author of "The M&A Mix Tape."

JK: Matt, thanks for being with us today. First, tell us briefly: What is private equity and how do these folks make money?

MK: Private equity is actually a fairly general term that can refer to a few different types of investors. The subgenus that's getting the Britney-style attention, though, is the leveraged buyout (LBO) shops. These guys primarily target massive deals that involve buying out a public company using a liberal helping of debt.

Once a buyer takes a company private, they use a good deal of the cash that the company generates to pay down the debt and de-leverage the investment. Often, they'll also dig into the company's business to improve operations. To actually lock in returns, the buyer will eventually sell the company, either by selling it to the public through an IPO or selling it to a larger acquirer.

JK: Goldman Sachs (NYSE:GS) is reportedly launching a $19 billion fund, and other banks are raising their own megafunds. Tell me, where is all this private equity money coming from? Can guys like you and me invest?

MK: Unless you have a big bank account that you haven't told me about, I'm guessing you're in the same camp as me and are boxed out from investing in the PE funds. PE funds are open to "qualified investors" as defined by the SEC. There are a couple different definitions of a qualified investor, but one of the most often used is a financial benchmark of either $200,000 in annual income or a net worth of $1 million.

A good deal of the money they manage comes from public and private pensions like CalPERS or the General Electric (NYSE:GE) pension fund. High-net-worth individuals that meet the "qualified investor" threshold, endowments (such as Yale's killer fund), PE funds of funds, and large banks are also big sources of money for the PE funds.

JK: Big deals have multiple buyers, who are normally fierce competitors. That sounds like a lot of big egos in the deal room. How do these guys get along?

MK: If you ask me, the PE world is a really funny combination of competitive and anti-competitive forces. These firms make money by delivering returns and attracting more investor money, because investor money means more fees. Competition amongst these firms is different from competition in other sectors, though. Pepsi (NYSE:PEP) might love to have 100% of households drinking their cola, and similarly, Cisco (NASDAQ:CSCO) wants to get all companies using solely their hardware, but because the pensions, funds of funds, etc., need to diversify their holdings, there's plenty of room for a bunch of funds to succeed.

As I see it, the key for the funds is to continue to produce enticing returns so that investors are still excited about giving them billions of dollars. Putting egos aside and working together not only reduces the risk from a deal for each firm, but it also takes away potential competitive bidders that would have otherwise pushed up the price. One thing that I can say for sure is that they're not teaming up because they're all best buds.

JK: There was more than $1 trillion (!) worth of M&A deals in Q4 2006. Have we reached a peak?

MK: Plenty of people will argue that we have hit a big-time PE peak. While it may be tough to keep up the recent pace of buyouts, as long as interest rates are low and there is plenty of debt to be had, we should continue to see an above-average number of buyouts.

I would guess the biggest risks to continued buyout activity are banks cutting down the availability of cheap debt and a big run-up in the stock market. Both scenarios would make buyouts more expensive and would probably slow down the pace of transactions as buyers look for the opportunities that will still fit their return target. A recession wouldn't be too fun for most of us, but if debt stays available, PE may benefit from cheaper prices.

JK: Are there any clues that a company may be a target for a private equity buyout?

MK: Typically, PE firms are looking for companies that generate a lot of free cash flow, since it's the excess cash the companies generate that they use to pay down the debt they've loaded on. In the same vein, stable and predictable businesses also make good candidates, because a business that will get hit hard during economic down years will have trouble keeping up with debt payments.

A reasonable price tag even after a premium is tacked on is also a must. PE firms set themselves a high bar for returns on their deals, and a high-priced stock is generally not of interest to a financial buyer. Companies that have been beaten down for good, but fixable, reasons, on the other hand, are prime targets. Because PE buyers have investment time frames that are measured in years rather than quarters, they are often willing to take on overhauling a company that public investors may not have the patience for.

Of course, while speculating on buyout targets can be fun, it's a tough way to seek out returns for individual investors. Not only is it tough to be right, but when a buyout does happen, you get your premium, which isn't always that big, along with your tax bill, and you have to figure out where to put your money next.

JK: Any final thoughts? Who do you like in the NCAA Championship game?

MK: In terms of private equity, even if we don't see more record-breaking deals piling on, we're definitely going to have our fill of PE headlines as Blackstone moves forward with its IPO. It also wouldn't be all that surprising if we saw some of the other big firms take this opportunity to think about a public listing.

As for March Madness, I was hoping for an underdog run from UNLV, but that ended last week when Tajuan Porter put up 33 points and went 8-of-12 from three-point land. At this point I'm behind Ohio State, and hoping that they can take one home for the Big Ten. Greg Oden will sure have his hands full with Georgetown's big man Roy Hibbert, though.

That's a wrap. Join us next week in the Foolish Forum for more discussion on the topics that matter to you.

Related Foolishness:

• A First Look at Blackstone
• The Softer Side of Private Equity
• You Bought What?

Think you can pitch your favorite stock -- or ditch your least favorite one -- in 27 seconds or less? That's just what we're doing over at Motley Fool CAPS. Come check out our 27-second stock videos.

Fool financial services editor Joey Khattab does not own any of the shares mentioned. Tell him what you think about the Foolish Forum. Fool contributor Matt Koppenheffer owns shares of Goldman Sachs. TXU is an Income Investor pick. The Fool has a disclosure policy.