The Perils of Investing in Private Equity's Wake

The secretive world of private equity has gotten a lot of unwanted attention this year, thanks to Mitt Romney's campaign for president. Romney founded and at one time headed private equity firm Bain Capital. While I have no interest in wading into politics, I think it's important that investors understand the damage these firms inflict on their targets' financial well-being. Using the experience of three well-known companies in the restaurant industry, I will demonstrate why you should avoid stocks that have come within private equity's injurious embrace.

Private equity's calling card
If there's one thing that every past or present private equity target (known in the industry as "portfolio companies") has in common, it's that they're drowning in a sea of debt. A private equity company purchases its prey in a manner similar to how a subprime borrower bought a house during the real estate bubble. It puts up a sliver of capital and then finances the rest by mortgaging the target company's assets. This is why private equity deals were once known as "bootstrap" or "leveraged" buyouts before the terms became uncouth.

One of the earliest leveraged buyouts, which I've discussed before, provides a case in point. In 1982, pioneering private equity firm Wesray, co-founded by William E. Simon, a Treasury secretary for presidents Nixon and Ford, paid then-conglomerate RCA Corp. $80 million for its unloved subsidiary Gibson Greetings Cards. Wesray put down $1 million in equity and for the rest secured a $79 million loan collateralized by Gibson's assets. Sixteen months later, Wesray took the company public in a stock offering that valued Gibson at $290 million. On an initial investment of $1 million, Wesray's partners reaped a $210 million windfall. Not bad for less than a year and a half's worth of work! Never mind that Gibson was then laden with a suffocating debt load.

With this in mind, it should be no surprise that most publically traded portfolio companies have significantly more debt relative to size than their competitors do. The experiences of Dunkin' Brands (Nasdaq: DNKN), Domino's Pizza (NYSE: DPZ), and Burger King (NYSE: BKW) serve as representative examples, each of which continues to suffer from the one-time affections of private equity firms like Kohlberg Kravis Roberts, Blackstone Group (NYSE: BX), or American Capital (Nasdaq: ACAS). As you can see in the table below, all of these companies have significantly more debt on their balance sheets than equity. And when you exclude intangible assets, all three have negative book values in excess of $1.4 billion.

Source: Second-quarter 2012 financial reports.

Dealing with the apologists
Now, it can't be denied that there are people -- namely, the industry's participants, their paid apologists, and others who simply don't know any better -- who argue that private equity firms make portfolio companies stronger and better able to survive in a competitive economy. The problem with this position is that it confuses the exception with the rule. The exception is illustrated by a company like office retailer Staples, which was pushed to embrace and subsequently dominate online office supply retail by its one-time private equity owner. Because most companies aren't as successful at discharging their debt, however, the Staples exception is just that: an exception.

The reasons for this are twofold. First, heavy debt burdens leave companies vulnerable to credit squeezes by the highly unpredictable and irresponsible financial industry. Have you ever wondered why companies as diverse as Lehman Brothers and Circuit City went out of business? The inciting cause for both was lost access to credit. And the same fate may soon consume Texas energy giant Energy Future Holdings, which was known as TXU prior to its $45 billion leveraged buyout by a consortium of private equity firms.

Second, the interest payments associated with large debt loads inhibit investment in growth and siphon off income before it reaches the shareholders. As you can see below, a full one-third to one-half of the three previously mentioned companies' operating incomes goes to creditors as opposed to shareholders. This compares to the restaurant industry's average of only 8%! Think about that for a second. A shareholder of an average company theoretically gets nearly twice as much from earnings as does a shareholder of a company that was previously exploited by a private equity firm.

Source: Second-quarter 2012 financial reports. The data refer to the first six months of 2012.

The truth about private equity
When politics are involved, as they are in the current debate about the virtues of private equity, truth becomes a relative concept, if not a completely irrelevant one. However, while there may not be obvious consequences to flawed logic within political discourse, the same cannot be said about the market, where faulty analysis often leads to tangible losses. It's for this reason, then, as well as those discussed above, that I'd urge any investor to think twice about investing in companies left in private equity's wake. In their place, try one of the stocks listed in our newest free report, "Middle-Class Millionaire-Makers: 3 Stocks Wall Street's Too Rich to Notice."