Private equity deals may collapse in cloudy times

By Neil Behrmann

November 2006:- The United Nations Conference on Trade and Development (Unctad) is beginning to fret about the explosion of global private equity deals. This is hardly surprising.

Private equity funds and, to a lesser extent, hedge funds accounted for around $135 billion or about a fifth of global mergers and acquisitions in 2005. The deals are likely to be even larger this year, says Unctad.

Private equity funds are forecast to raise around $300 billion from their investors this year, compared with just over $40 billion 10 years ago. This money is finding a home in numerous takeovers that are overpriced.

The basic aim of private equity financiers is to buy private companies as cheaply as possible, discard unprofitable divisions and then list the company on the stock exchange at a huge profit. Another deal is to organise a consortium to buy a listed company, improve its management and fortunes, and spin off subsidiaries.

The majority of private equity funds invest in their own countries. But a growing proportion of investments take place in foreign developed and emerging countries, especially Asia . Besides technology and telecommunications, investments now include infrastructure.

Australia 's Macquarie Bank is active in such deals and this month bought Thames Water, the privatised UK company for a whopping 8 billion (S$27 billion).

Thames supplies Londoners with water. Locals who have experienced leaking pipes and water restrictions in England 's wet climate are now fretting that the ownership of this vital resource has shifted from German owners to other foreigners.

Other private equity deals in the past few years included European real estate, the purchase of banks in emerging Asia , and finance and leisure industries in Japan .

Growing numbers of institutional investors are placing money in private equity funds. Private equity investors include Capital Asia, Asia Pacific Hong Kong and Dubai International Capital.

Private equity funds have played a major role in business expansion. They are prepared to invest in promising new ventures and back financially strapped companies with high growth potential.

As Unctad says in its World Investment Report: 'Venture capital from foreign private equity firms may well help developing countries create firms that could become a Xerox, a Microsoft or an Apple of the future.'

The disadvantage is that private equity fund managers can be brutal in their dealings with distressed company acquisitions. The Korean public was furious when US private equity funds Newbridge Capital and Lone Star sold Korea First Bank in 2005 and Korean Exchange Bank in 2006.

The main concern, however, is that the huge flow of capital from pension funds, banks and other investors has created a private equity bubble, similarly to real estate and commodities. A substantial portion of multi-billion dollar private equity fund corporate acquisitions is financed by debt and this is dangerous.

The surge in financial asset prices since the 2003 bear market means that it is much more difficult for private equity funds to find bargains. Private equity funds have had to raise the leverage, ie the level of borrowings to buy these companies.

So far, private equity funds have relied on cheap finance. Some have taken risks on the currency markets by borrowing yen and Swiss francs at much lower interest rates than the greenback, British and euro currencies. Interest rates and the currencies in which they borrow could rise and increase the debt burden.

The traditional private equity strategy was to buy and hold the investment for several years, giving the company time to grow and improve profitability.

Experienced private equity firms continue to pursue this strategy. But growing numbers of new private equity managers and hedge funds have become involved in private equity transactions. These managers want to turn a profit as quickly as possible to meet the expectations of their investors. Their tactics inevitably raise the risk level.

Investment in pricey acquisitions is based on continuation of good business conditions. The present global economic outlook, however, is cloudy. A soft landing in the US economy is by no means certain. If the US and global economies turn downwards and business deteriorates, profitability of private equity acquisitions will not meet expectations.

Cash flow would be inadequate to finance the interest payments and banks could call in the loans. Private equity funds could thus face the prospect of investment failures. Unctad's stark warning is indeed timely.

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