Secrets Of Success: I don't want to burst the bubble, but...

There is a lot of good sense in the Financial Services Authority's discussion paper on private equity, published this week. While this ragingly popular new asset class has little immediate impact on most private investors, the story of what is happening in the sector is still an important one for all of us, as it touches on some important issues that do directly affect the quoted stock market.

It is true, as the FSA points out, that the term "private equity" covers a wide range of different types of fund, from very large leveraged buyout groups to small venture capital. There is always a danger of making generalisations about such a diverse range of investment operations (though that has never stopped us in the past).

The sector of the private equity market that is growing very fast, and attracting the regulators' attention, is the largest funds that will typically make a bid for a quoted company, take it private and then refloat it on the stock market after a period of restructuring.

The turnaround is usually carried out by a highly incentivised management team, sometimes the one that was managing the company before, and financed with debt secured against the company's cash flows.

The classic model of this kind of activity was the takeover of RJR Nabisco by KKR in the 1980s, a deal that features in the book Barbarians At the Gate. If you think image is important in these matters, you have to admire the way in which the leveraged buyout industry (with all its negative associations) has managed to rebrand itself with the more comfortable-sounding name of private equity.

Private equity has been growing like mushrooms in the last three years, with a string of ever-larger fund-raisings and deals. All this activity is one of the main reasons why stock markets have been so strong, particularly in the mid-cap area, which is where many of the private equity bids have been directed. (The FTSE 250 has outperformed the All-Share index by 34 per cent over the past three years.)

The FSA paper underlines that, in practice, most private equity funds in the UK have to date been funded by overseas investors. UK pension funds, however, have been increasing their commitment in the hope of gaining some of the higher returns private equity has produced. According to the FSA, UK investors in total put £5.9bn into private equity in 2005, five times the amount raised in 2004. This was still only about 20 per cent of the total raised by UK funds (another good example of the City's strength in these fields).

A big selling point, as with hedge funds, has been the argument that returns from private equity are not well correlated with equity markets, the only problem being that returns from private equity are notoriously lumpy, with most gains going to a small minority of participants. If you don't get into the right fund, in other words, you are likely to fare pretty poorly. Returns are also bound to come down as more money pours into the sector.

One indication of the rapid growth of private equity is that deals are getting bigger all the time, to the point that private equity funds are increasingly clubbing together to make bigger bids possible. The Danish telecoms company TDC set a new record for European deals earlier this year, at $12.5bn. It is a safe bet that some even bigger targets will be attempted in due course, if only because so much money is flowing into the sector that there is no other way it can find a home.

In its paper, the FSA raises some concerns about the potential risks of the step change in private equity. High among these is a risk of leverage reaching dangerously high levels. Many of the bigger deals are increasingly funded with complex loan arrangements where it is not clear where the ultimate exposure lies. A default or failure by a big LBO fund, which the FSA says is bound to happen eventually, could have obvious implications for the financial system.

Why should investors be concerned about this? One reason is that one effect of so many M&A deals being funded by private equity groups is to shrink the size of the quoted equity market. While investors in companies that are bid for get a nice premium in the short term, in the longer term a shrinking equity market is not healthy. A thriving equity market requires a wide range of listed vehicles.

A second concern is that private equity is already having an impact on other financial assets. Holders of corporate bonds, for example, have faced a series of losses as a result of companies whose bonds they own being loaded with ever more debt after a bid. Equity fund managers have also been moaning about some of the large gains made by private equity firms, which in effect come at their expense. They sell the shares in Company X at 100p to a private equity bid and then have to buy them back at 200p a few years later when the invigorated company refloats.

So the success of private equity to date raises some worrying questions about the adequacy of shareholder influence over managements. There is no doubt that, free of the constraints of operating as a listed company, managements seem able to produce much more impressive improvements in performance.

Is that because the private equity model is really a more efficient way of incentivising managements? Or is it simply that the easiest short-term fix for any company is to take on more debt to leverage its returns? Extra borrowing works well when the cost of borrowing is held at artificially low levels, as it has been for several years, but it comes back to bite you when the economy slows and borrowing costs rise.

Generalisations, as I have said, can mislead. Nevertheless, I see no reason to change my view that private equity is developing all the classic signs of a bubble asset class, with scores of new investors chasing returns that cannot be sustained indefinitely.

Having said that, you can be certain that there will be some mouthwatering returns made by those who can ride the current boom period and succeed in getting out before the current cycle runs its course.

jd@intelligent-investor.co.uk