Is the Private Equity Market Frothy?- Not Necessarily

Many articles have been written about the record levels of large deals being proposed or completed in the private equity markets, from Harrahs to HCA. Pundits have offered up that this is due entirely to the massive amounts of cash that have been raised by private equity firms and those firms chasing bigger deals in order to invest the money. While there is some truth to that, I would offer that there are other factors at work.

First, the balance sheets of Corporate America are at record levels of conservatism. Corporate America currently has record amounts of cash and low levels of debt at a time when interest rates are still quite low on a historical basis. This is in part due to the markets skepticism about large scale M&A transactions, and part because of the volatility of the past associated with more aggressive balance sheets. In short, in todays regulatory environment and with frivolous lawsuits being filed daily, it is easier and safer for CEOs to do nothing, and let cash pile up, rather than to do the best things for shareholders. While those CEO's would acknowledge that Corporate Finance 101 would tell you this is inefficient, they would argue they just want to be careful and will return money to shareholders over time with dividends and buybacks. This will usually satisfy an unsophisticated market. To a private equity firm with deep pockets, however, this is a unique opportunity. By taking a company private and therefore pulling it out of the regulatory constraints and litigation world, private equity firms can do what company managers should have been doing all along- optimizing their capital structures and trying to grow shareholder value. While sometimes this will be reflected in significantly increased leverage, or more aggressive growth and acquisition plans, private equity firms are rarely rewarded for crippling a company's prospects. As such, private equity firms serve as a check to management inefficiency and conservatism.

The second factor going on is that the primary suppliers of capital to the private equity space are struggling to find alternatives that will generate 10%-15% consistent returns. Equities seem unlikely to be able to consistently deliver that level of return, bond rates are around half that in terms of coupon, real estate has had a great run, but seems unlikely to continue at high levels; so where to turn? In the last decade, private equity was seen by pensions as a diversification tool and an opportunity to generate maybe 20-25% returns on relatively small dollars. In todays market, the large buyout firms are essentially investing in the public equity markets, but doing so more efficiently. As such, 10%-15% seems more achievable and the private equity firms can do so with larger amounts of capital. From a pension fund's standpoint, this is a perfect fit. Lower returns than before, but the ability to put much more money out while exceeding the target returns necessary to fund their pensioners retirement payments.

With these facts as a backdrop, I think that the current perceived `bubble' in private equity is unlikely to burst anytime soon.

Let me know what you think.

Bob Crants