LBOs Are Back

Their returns are fat and fast -- for now

By MICHAEL SANTOLI

WITH THE DOW REACHING a 45-month high this month, the stock market has given investors a
pretty good ride lately. But the profits spun by private buyout firms in the past year, make the
market seem as if it's moving backwards.

Buyout shops, also known as private-

equity firms, have long been viewed as
the smart and patient money, willing to
buy and retool companies over several
years before reaping their returns.

But in the past year, the buyout industry

has represented the easy and fast
money, taking advantage of pliant
capital markets to turn billions in quick
winnings for themselves and their
investors.

And these takeover artists have been

anything but patient lately, both in
putting money to work and harvesting
their winnings.

Consider: In 2004, leveraged-buyout

volume hit $68.3 billion, according to
Thomson Financial. That was the
highest total since 1988, the year that
featured the manic dogfight for RJR
Nabisco, the climactic deal of the
'Eighties LBO boom. What's more, LBOs
last year represented more than 8% of
all domestic merger-and-acquisition
activity, the highest percentage since
1989.

On the payoff side, private-equity

players cashed out of enough
investments to return a whopping $36
billion in net cash to their investors in the
nine months through September.
Though the investors are mainly pension
funds and other institutions, wealthy
individuals have also been getting in on
the action, through their private banks and sometimes directly.
All told, private-equity firms as a group generated a 19.3% return to their limited partners in the
year ended Sept. 30 (the latest numbers available), according to Cambridge Associates. That
return is even more impressive considering it's the actual return enjoyed by investors -- net of all
fees, expenses and the typical 20% cut of profits that private-equity firms levy.

Yet even those numbers don't properly convey the rich supply of huge, quick profits booked by
some of the larger, sharper players in the $800 billion private-equity industry. In the past year, it
became almost commonplace for LBO firms to triple or quadruple their initial investments by
buying, recapitalizing and selling companies in a matter of months.

In fact, there were so many home runs in this business last year that
if takeover bankers wielded bats instead of briefcases, they'd
probably be facing congressional steroid hearings now.

LBOs, since their advent in the 'Seventies, have displayed a pattern

of superior returns over market cycles, with annualized profits
handily beating those of the public equity indexes. Buying companies
with lots of borrowed money, cutting costs, breaking up or improving
the businesses and then selling out has been a good recipe for
turning a buck.

But, typically, the returns have been lumpy and buyout portfolios often spent long incubations
over some fallow years.

The recent bounty of fast and nearly effortless profits has been made possible by a rare
synchronicity of welcoming market conditions for buyout artists.

The high-yield bond market, most crucially, is all but begging borrowers to take on low-cost debt.
With historically narrow credit spreads over unusually low Treasury yields, junk debt has almost
never been cheaper or more readily available, with demand for high-yield bonds far outstripping
supply. This allows LBO firms to act quickly on new deals, and the low debt-service costs
embolden them to pay more for companies.

The junk market is so obliging and high-yield investors so hungry for paper that LBO firms have
been rushing to issue new debt on already-leveraged companies they've bought, strictly for the
purposes of collecting a cash dividend. There were 77 such dividend recapitalizations last year,
worth $13.5 billion, up from $6 billion in 2003 and $2 billion in 2002.

At the same time, the stock market has become more receptive to initial public offerings, opening
one popular exit window LBO firms use to seal profits.

The supply of businesses to buy has been strong, too, as large companies look to sell lagging
divisions even as other companies have been a bit risk-averse in competing with buyout shops to
bid for acquisitions.

Colin Blaydon, director of the Center for Private Equity and Entrepreneurship at Dartmouth's Tuck
School of Business, says that these conditions freed LBO firms from the tight financial conditions
that prevailed through the early years of this decade, and the firms rushed to take advantage.

"In the last 18 months," he says, "the stars have really aligned." Initially, the accommodating
markets allowed LBO firms to liquidate seasoned investments they'd held through the downturn.
"Then people realized they could buy a company, dress it up, do some financing to leverage it up
and within six months pay a dividend and in some cases execute a sale," he says.

This describes the dream-like environment that allowed Blackstone Group to earn four times its
initial investment in the chemical company Celanese in nine months, sent Kohlberg Kravis
Roberts on the way toward tripling its outlay in PanAmSat since August and let Bain Capital enjoy
a 30% return in a humble Canadian phone-book printer in four months.

When the LBO firms' 20% cut of the profits is factored in -- a jackpot that flows right into the
partners' pockets -- it's no surprise that the likes of Blackstone chief Stephen Schwarzman could
afford the priciest apartment in Manhattan a few years back.

All of which prompts the spoilsport question: Is this just about as good as it gets for the buyout
types?

The answer, according to industry participants and observers, is that it probably won't get any
better than this for private equity prospects -- but things could stay rosy for a good while longer. In
other words, the buyout market is likely in the process of overheating, but isn't ready to boil over
just yet. As with any market cycle, lush profits breed popularity, and fresh money is now flocking
to the corporate-buyout sector in record amounts.

As much as $250 billion could be raised via 800 funds in 2005, forecasts research firm Private
Equity Intelligence. That would dwarf the $136 billion taken in last year, and if that projected haul
is reached it would represent an enormous 30% of existing private-equity assets.

Some of this bonanza of eager money is slated for a new class of "mega funds," including a
reported $10 billion new fund being raised by Blackstone -- 50% bigger than the industry's largest
present fund -- and a planned $6 billion entry by Thomas H. Lee.

This torrent of new money represents avid demand for private-equity exposure among
institutional investors such as pension funds and endowments. These fiduciaries have seen long-
term returns from this asset class of about five percentage points over U.S. stock returns, and
they are raising their allocations in pursuit of those results.

The quick flips of companies in recent years are both a product of, and contributor to, the frenzied
fund raising. Buyout pros explain that any firm hitting the road to raise a new fund must be able to
show some big, tangible recent scores, which spurs fast deal turnover.

And last year's resultant return of fat profits to private-equity investors also probably put many
institutions below their targeted allocations, further fueling demand for new funds.

It's notable that the heaviest share of new money will be heading toward the most mature and
efficient segment of the private-equity business -- large U.S. and European buyouts -- raising
questions about how rich the opportunities for outsized profits will be in years to come.

There's some competitive logic to private-equity houses raising huge funds, for sure. With $10
billion-plus acquisitions no longer novel, buyout sponsors feel they need a hefty arsenal to
plausibly compete. Because LBO funds can't prudently commit a high percentage of their assets
to one deal, a larger cash store allows them to move quickly on elephantine deals.

In fact, one trend in the business is buyout firms collaborating in bids. Such "club deals" are a
way for private-equity folks to compete while limiting the concentration of their bets. But note that
in past cycles, when one-year private-equity returns have approached the 20% level seen of late,
funds raised in the subsequent couple of years have suffered lesser results.

If only the onrushing supply of new private-equity money were the only threat to the happy status
quo.

Perhaps the greater looming concerns are the incipient return of big, cash-rich companies to the
acquisition field and the burgeoning involvement of hedge funds in the buyout game.

After a post-bubble stretch in which companies were risk-averse and inwardly focused, many are
now sodden with cash and need to buy their way toward growth.

As for hedge funds, they are facing public markets largely bereft of big misvaluations and juicy
opportunities. So they are moving in on the M&A business, like sharks swimming to chum.

Most famously, Ed Lampert of hedge fund ESL Investments has taken control of Kmart and is
now merging it with Sears Roebuck. But Cerberus Capital, D.E. Shaw, Highfields Capital and
others have also recently made bids for whole companies. Note last week's news that Cerberus,
a large fund that made its name in distressed-company investing, joined with Goldman Sachs and
Kimco Realty in a bid for Toys "R" Us.

This means more fast money chasing deals and a greater chance for reckless check-writing in
auction scenarios, say industry observers.

Many longtime buyout pros have expressed concern that the entry of hedge-fund money into their
realm could inject new risks into the business. A trader's mentality, as opposed to the usual mode
of buying and then helping to operate a company, may augment the short-term orientation of
today's buyout market.

Tom Dorr, chief investment officer for private equity at Morgan Stanley's Alternative Investment
Partners division, says the volume of cash in corporate coffers and the $1 trillion or so in hedge
funds "dwarfs" the amount that can be brought to bear by dedicated private-equity funds. If
companies and hedge funds turn more aggressive in vying for acquisitions, that could compress
private-equity returns and raise risk levels in the sector over the intermediate term.

Along with hedge funds' intrusion into the once-cloistered LBO game, large companies are
showing signs of opening their fat wallets in pursuit of acquisitions.

SAYS DARTMOUTH'S BLAYDON: "After the bubble, strategic buyers became more disciplined
and financial buyers [LBO firms] could bid more. In the manufacturing sector in particular, we saw
financial buyers outbidding strategic buyers, which was never seen before."

But that window of opportunity for buyout pros seems to be closing with the rise in corporate risk
appetites lately.

Already, valuations of buyouts have begun to rise -- one sign of intensifying competition for
assets. Average leverage of LBO targets is estimated to be approaching record levels of 5.1
times cash flow, defined as earnings before interest, taxes, depreciation and amortization.

Kevin Callaghan, a managing director with the private-equity shop Berkshire Partners and an 18-
year veteran of the industry, expresses concern for the full-speed-without-a-helmet nature of
some recent deals. "With the credit markets freely flowing, people forget that defaults can occur
and [corporate] earnings can decline," he says. "A certain percentage of deals will crap out. When
you can't get financing and everyone's going bankrupt, that's a great time to put money to work.
Now, with everyone flush with capital, on the margin some businesses are being financed today
that in a few years people will scratch their heads and say, 'How could they have done that?' "

Callaghan says that some of today's gamier deals are, in effect, seeding the distressed-debt
market of a few years out.

The friendly bond and IPO markets that have allowed rapid turnover of buyouts can also erode
whatever discipline exists in private-equity land. LBO backers, through their history, typically
bought troubled businesses, with an eye on nursing them toward the next cyclical upturn.

With more focus on quick entries and exits, the hurdle for what constitutes a viable deal is being
lowered. Eventually, that's the kind of behavior that creates sloppy deal-making.

The sober warnings about an overheating buyout climate are certainly worth heeding, especially
for institutions now shaping their return assumptions for the coming years. As noted, buyouts as
an asset class have returned about five percentage points above public-market equities over the
long haul. That record, which amounts to the compensation investors receive for placing funds in
a risky and illiquid market, may hold up over time, but some lean years might muddle the near
term.

For the time being, the LBO market probably has some room to run with the stars in alignment
before buyers begin sowing the seeds of the cycle's demise.

Of course, a little excess aggression among acquisitive buyout players can work to the benefit of
stock-market investors, at least while the dealing is being done.

A couple of hundred dollars in cash overseen by itchy-fingered takeover hunters with no qualms
about leveraging their investments by a factor of five will, at the margin, help public-market
valuations -- as long as the bond market continues to be as forgiving as it has been.

The hearty appetite of financial acquirers will probably work to the immediate benefit of
companies looking to divest lagging divisions, a kind of transaction that is smack in the sweet
spot of private-equity firms' focus.

In addition to the ongoing auction of Toys "R" Us' retail toy division, big companies with stated
intentions of unloading unwanted units include Sara Lee (its European apparel and meat
divisions, and its U.S. retail coffee division) and Kerr-McGee (the chemicals line).

A fervent buyout climate isn't a panacea for shareholders market-wide. And beware brokers
pitching IPOs in which the smart-money shops are ringing the cash register. Still, a bubbly LBO
market can help support equity values and energize animal spirits. And given the escalating
competition for acquisitions, some wealth will probably be transferred from the smart-money
dealmakers to the public -- for a change.