Privatizing Profits

Finally, some euphoria. Or maybe not…

Private equity firms are buying public companies like there's no tomorrow. The activity has been downright frothy. A ton of private cash is chasing deals right now. Private equity and LBO (leveraged buyout) firms are competing and starting to pay bigger premiums to win deals, making the financial soundness of those deals shakier.

Private equity firms made a record $738 billion in buyouts in 2006, accounting for more than 20% of the $3.6 trillion in global M&A this year (according to Thomson Financial).

However, the reasons private parties are buying public companies are largely the same reasons public companies are merging. In both cases, firms are able to use positive cash flows or borrow at cheap interest rates relative to the yield on the earnings of the target company. Quite simply, these investors are able to acquire companies that produce an earnings yield higher than the cost of capital used to buy them.

Lately the press has framed the sheer volume of M&A and private equity activity as an economic hazard, likening the scenario to 1999's record year for merger activity leading into the bear market.

Today's environment is much different. In 1999, mergers were overwhelmingly financed by inflated stock shares, and huge premiums were paid on the basis of questionable financial strategies and overly optimistic forecasting. Today, conditions of cheap borrowing costs and cash-rich balance sheets relative to high equity earnings yields make most acquisitions automatically accretive to earnings. And because the deals are largely financed with cash, acquiring firms will tend to be more disciplined in paying premiums and adding to earnings. This is rational economic activity, not a mania.

While exuberance could be bad for private equity markets because the higher premiums paid will evaporate their gains, there's an important upshot. All this activity is a good thing for public shareholders. High activity of private equity purchases and leveraged buyouts will continue to reduce the supply of equities and raise premiums paid for public shares.

Bad times for private equity ahead? Maybe. But either way it's good times for public stock investors.