Because of a tidal wave of private equity (PE) deals and M&A, a total of 17 companies will disappear from the S&P 500 so far this year. With a chunk of stock gone and a tepid IPO market, it's no wonder the index is about to hit a new high. This may be a wonderful thing in the short term, but Foolish investors need to be wary of the possible consequences when the boom turns to bust.
To pull off a megabuyout, one or more PE firms will write a check for 10% to 20% of the purchase price. The rest of the financing will come from myriad layers of debt, such as senior secured credit facilities, bridge loans, junk bonds, and mortgage loans. With low interest rates and the growth of global capital markets, such debt has been cheap lately.
Because investment banks like Goldman Sachs (NYSE:GS), Merrill Lynch (NYSE:MER), and Morgan Stanley (NYSE:MS) have their own PE divisions, they often invest alongside other PE firms or even provide all the equity financing. So how can investment banks give sound advice if they are also trying to get a piece of the company?
It's a big issue, but the investment banks don't seem to be concerned. Keep in mind that the fees for megadeals can be more than $100 million.
So why is management at the companies not concerned? Managers also have a conflict of interest. On the one hand, they have a fiduciary responsibility to represent the interests of shareholders. Yet in a buyout, the management team may have an opportunity to invest in the deal as well as get a slug of stock options. As the debt is paid off over time, this equity gets bigger and bigger.
It's a cozy arrangement. Wall Street firms get lucrative fees and perhaps a piece of the deal. PE firms get reasonable valuations and access to cheap debt. Senior management teams get an opportunity for a big payday without having to worry about the regulations of public markets.
It's absolute nirvana, huh?
Despite all this, there are some signs of pushback. Look at a recent opinion from Leo E. Strine Jr., who is the vice-chancellor in Delaware's Court of Chancery. He was concerned that in the buyout of Netsmart Technologies (NASDAQ:NTST), the company did not seek out potential strategic buyers. Strine said one reason is that managers may have feared they would lose their jobs. Whatever management was thinking, Strine thought Netsmart was being "unreasonable."
While the Netsmart deal was only $115 million, Strine's opinion may be a message to Wall Street that there needs to be more consideration for the interests of shareholders.
We are also seeing pushback from major shareholders like Fidelity Investments and the California Public Employees' Retirement System. These institutions have a fiduciary responsibility to get the highest returns for their investors and have shown a willingness to "just say no" on some buyout deals. Consider the $19.35 billion going-private transaction of Clear Channel (NYSE:CCU). Because of the resistance from Fidelity and Highfields Capital Management, Clear Channel increased its bid twice and is now providing existing shareholders with about 30% of the post-public company.
Even Federal Reserve Chairman Ben Bernanke sees "significant risks" with private equity. At a conference last Thursday, he said there are risks for banks that are providing equity bridge financings, which are short-term financings that help close a transaction.
The issue? If a buyout target runs into problems, the equity bridge has less seniority in a liquidation, and this could put a bank's balance sheet at risk. Some of the top providers of equity bridges include the majors like Citigroup, Bank of America (NYSE:BAC), and JPMorgan Chase (NYSE:JPM).
Keep in mind that when the private equity boom imploded in the late 1980s, major commercial banks had exposure to bad buyout loans. By 1990, there was a credit crunch, and even Citigroup and Chase could not raise $4.2 billion to arrange for the UAL buyout. Heavily leveraged companies like Federated and Allied Stores declared bankruptcy.
It took several years to work out the problems.
So are things different this time? Will things just go up and up? I doubt it. Whenever markets are frothy, it's easy to smooth over mistakes.
We are also in new territory because the targets of buyouts are now megacompanies. While it's true that these companies tend to have strong balance sheets and cash flows, there have been some deals in fairly risky industries. An example is the $17.6 billion buyout of Freescale Semiconductor. What with the troubles of its customer Motorola, the company has posted weak financials lately.
I certainly can't predict the timing of an implosion. If you look back in financial history, these things come without much warning. But when the bursting of the PE bubble happens, I'm sure it won't be pretty.
Wait! You're not done. Go back and read the other arguments about private equity. Then vote for the winner.
Bank of America and JPMorgan Chase are Income Investor recommendations. Fool contributor Tom Taulli, author of The Complete M&A Handbook, does not own shares mentioned in this article. He is ranked 1,898 out of 28,990 rated investors in Motley Fool CAPS. The Fool has a disclosure policy.
