Private equity rolls on

BYLINE: Leela de Kretser

The biggest story on Wall Street in 2006 will drive the US market again this year, writes Leela de Kretser

AS IF private equity firms hadn't already bought everything not nailed down in 2006, along come the Wall Street analysts predicting no end to the massive buyouts in 2007.

Private equity, the biggest business story of 2006, will continue to drive a flurry of merger and acquisition activity, say experts surveyed by BusinessDaily.

The approximately $US1.4 trillion spent in US mergers and acquisitions last year -- up from $US1.2 trillion in 2005 -- is forecast to be bettered this year, says Thomson Financial.

''Our forecast of some $US1.5 trillion in US M&A for 2007 would mark the third consecutive year of better than $US1 trillion in annual M&A volume,'' Thomson said in an end-of-year research note to clients.

''The only other time such a streak occurred was in the three-year period from 1998 to 2000. Deal volume should expand in the financial services, healthcare and technology sectors in the year ahead.''

After four straight years of double-digit percentage increases in US M&A activity, Thomson predicts the volume will increase modestly in 2007.

''Our moderate view is based in part on the opinion that the recent strong pace of deals may compel some active buyers to pause and absorb the operations recently acquired,'' Thomson said.

''Also, a concern by some regulators over the activity and bidding process of club deals may dampen deal flow.''

By far the greatest factor that contributed to the spending spree was the stockpiles of cash raised by private equity firms in the past three years.

Harvard Business School professor Josh Lerner said that by the end of the third quarter of 2006, private equity firms had raised more than $100 billion -- thanks, in part, to historically low interest rates.

''I think it's clear that the last couple of years have seen an incredible surge in buy-out activity, which is a confluence of different things at the same time,'' he said.

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''The willingness of debt markets to be generous with financing for what are often risky transactions, and it's fair to say that in part this reflects that traditional investments have been supplanted by hedge funds and others who have a somewhat different risk-return profile,'' Lerner said.

''But you have also seen a shift in the equity side as well, where you are seeing a lot of institutions especially outside of the US who are willing to invest in private equity, and this is driven by the hunt for yield.''

Analysts say the hunt for yield will continue this year, but Lerner warns that the worst time to invest in alternative investments is when it's typically the most popular to invest in alternative investments.

A LL the hype surrounding private equity the past year has Thomson predicting a moderate deceleration in the growth rate of buyout, fundraising and acquisition activity.

''Recent explosive growth was fuelled by excessively low interest rates, extremely attractive earnings multiples in the public equity markets, historically tight credit spreads, and sustained above-trend US GDP that produced 13 consecutive quarters of double-digit earnings growth from the S&P 500,'' Thomson said.

''With interest rates now higher than where they were in prior years, the US economy returning to trend or slightly below-trend growth, and with the equity market trading at less of a discount in terms of forward market EPS multiples, a modest deceleration in buyout activity is anticipated from historically elevated levels.''

Debt analysts say the unusually high levels of liquidity in the US markets right now should increase the risk of buyouts this year.

Steve Bavaria, head of bank loans and recovery ratings at Standard & Poor's, said: ''There's an awful lot of debt being taken down, and certainly a lot of it relates to M&A, private companies going private and I think it's driven by the economic opportunity seen in deals, but especially driven worldwide by the enormous amount of liquidity looking for a home.

''The danger is whenever you have an imbalance, in this case where there is an excess amount of liquidity seeking investment opportunity, an awful lot of people trying to find homes for the liquidity, you have a lot of incentive to stretch too far to do deals that in a balanced credit environment wouldn't take place.

''This is eventually going to haunt people when the business cycle turns. Unless the credit cycle has been repealed, and that would mean doing away with hundreds of years of history, then eventually one's likely to see a turnaround.''

But Bavaria said the risk of a 1980s-style bust was more likely to be felt next year than this year.

''From the people I talk to in the market, I think a lot of people in the US feel they have an enormous amount of confidence going into 2007,'' he said.

''We don't have a crystal ball, anymore than anyone else, but I think it's more likely the chickens might come home to roost in 2008.''

Hugh Johnson, a founder of fund manager Johnson Illington Advisors, agrees that excess liquidity will be the driving force this year.

''The works that I've done indicate that there is ample liquidity to drive the markets higher in 2007,'' he said. ''The level of funds in institutional coffers is extraordinary.

''Assuming the performance of the equity markets doesn't become too speculative or outlandish, assuming valuations do not become too high, that liquidity is likely to drive stocks higher in 2007.''

W HILE economists argue that the current valuations of companies have not become overblown, Johnson said the risk of private equity firms overpaying loomed on the horizon.

''We are getting to the edge of speculation right now,'' he said.

''Speculation in the strictest literary economics for investors is when they buy assets that are over-valued with the fantasy that they are going to become even more over-valued. We're not there yet, but we're getting close enough that you better be careful.

''The problem is speculation is followed by financial distress and that's when there is a rush for the exits.''

Johnson said investors needed to be aware that several factors could send the economy into a tailspin next year.

''The good news of declining oil prices has offset the bad news of declining housing prices,'' he said. ''If oil prices rise, and you are no longer getting help from oil prices, you could get a hard landing.''

Johnson also warns that the Federal Reserve could raise interest rates or the housing market could deteriorate more than expected.

''Then there are a number of possibilities, such as a hedge fund implodes,'' he said.

But Richard Peterson, of Thomson Financial, points out that speculation is very low in terms of private equity buyouts.

The average premium on deals in the 1980s was 50 to 60 per cent, compared with 14 per cent this year.

''I think, in general, the M&A environment is going to be positive,'' he said.

As for crystal ball predictions as to what companies or industries will attract attention, Peterson has some valuable advice for investors -- put your money on the real winners from all the merger and buyout activity.

''At the end of the day the winners have been the investment banks,'' Peterson said. ''While there is no doubt that the activity will continue, the nearest thing to a sure thing is the banks themselves.''