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SOURCE:  USA Today Newspaper.  Private equity firms, which receive the bulk of their funding from public pensions, are now the most significant risk to the integrity of the financial markets. As Krantz notes in this excellent article, these firms are often nothing more than Leveraged Buyout firms or LBO's.  This has been a central claim of Parish & Company for some time, specifically that many of these firms are playing an Enron like debt shell game and in the process extracting obscene "carry fees."  It is encouraging to see a leading reporter like Krantz of USA Today shed light onto the significance of this area although this particular article just scratches the surface.  Parish & Company is quoted in the latter half of the article and, although my comments were refuted by a law firm that respresents these private equity firms, they are indeed, as the British say, "spot on."


Private equity firms spin off cash
By Matt Krantz, USA TODAY
They've bought Hertz. They've swallowed La Quinta and Neiman Marcus. They've even snapped up Toys R Us and Dunkin' Donuts.

"They" are the wave of maverick investors and some-time turnaround artists storming Corporate America under the banner of private equity.

Private equity firms are arguably the hottest thing on Wall Street right now, packing the financial firepower to buy all but the nation's largest companies. Their reach into the financial markets stands to transform the stock market's landscape by putting a growing number of brand-name companies out of the reach of average investors while also putting many retirees' pension and retirement funds into much more speculative investments than ever before.

Essentially a revamped version of the leveraged buyout firms of the 1980s, these firms buy undervalued or underappreciated companies, fix them up and sell them for a fast profit, sometimes in as little as three years. Their secret sauce is the use of debt — usually as much as 70 cents of every dollar they invest. Because they pile debt onto the companies they buy, private equity firms free up their own cash, allowing them to make additional investments and maximize their potential returns.

Their pitch, the cold-hard capitalistic mission of mining value from rusty companies, is causing excitement among wealthy investors, pension plans and endowments, which are practically lining up to get a piece of the action.

"The money keeps piling in" says Chris Shepard, head of corporate finance at Imperial Capital.

And quite a pile at that. The amount invested in private equity hit $139.6 billion in 2005 and was twice as much as in 2003, says Tobias Levkovich, strategist at Citigroup. That's more than the $135.8 billion that flowed into stock mutual funds last year.

"The growing cash buildup at private equity investment houses may very well be the most important developing financial force today," Levkovich wrote to clients.

Private equity also is luring brain and star power. Former General Electric CEO Jack Welch, Black Entertainment Television founder Robert Johnson and U2 front-man Bono have all taken the private equity plunge. Welch has joined Clayton Dubilier & Rice to help with strategic planning on operating companies, Johnson created a private equity firm that will work with larger firm Carlyle Group, and Bono has joined the private equity firm Elevation Partners.

In the last year the big U.S. companies disappearing into the private equity fold included Neiman Marcus, purchased for $4.9 billion in October; Toys R Us, bought for $6.6 billion in July; and computer services firm SunGard Data Systems, for $11.3 billion in August. The biggest private equity deal in years closed in December when a group of firms bought the Hertz rental car company for $15 billion.

If current trends persist, it could be just a matter of time before the biggest private equity deal of them all — the $25 billion takeover of RJR Nabisco by Kohlberg Kravis Roberts in 1988 — is surpassed.

If all this seems familiar, it should. If you remember Barbarians at the Gate, Gordon Gekko and the leveraged-buyout craze of the 1980s, you've seen the prequel to this story. LBOs are back, only they've rebranded themselves private equity and are vowing a happier ending. Even many of the actors are the same, including the big players in the '80s such as Carlyle Group, Texas Pacific and KKR.

As similar as the return of private equity might seem to the 1980s, the firms say this time it's completely different. Instead of buying companies and dismantling them, as was their rap in the '80s, private equity firms install experienced management teams that can squeeze more profit out of underperforming companies.

Critics say private equity firms are up to the same old tricks and are taking short-term profits without regard for the long-term outlook for the companies they buy.

"Private equity firms have repeatedly extracted cash from companies knowing there was a significant risk they will later run out of funds and be unable to raise more," says Gary Diamond, a restructuring adviser for Berger Epstein & Garber.

While the two sides debate the pros and cons, one thing that seems pretty clear is that private equity's huge popularity is having far-reaching effects. One of the most significant outgrowths of private equity is the attention it is getting from public retiree funds. The flat returns from publicly traded stocks have driven giant public pensions, which manage the nest eggs for teachers and other state employees, increasingly into private equity.

Last year, public pensions had 1.6% of their portfolios invested in venture capital and private equity, twice their 0.9% allocation in 2004, says Wilshire Associates. That might not seem like much until you consider that Wilshire says public pension funds manage $2.1 trillion.

Private equity also has reduced the ranks of publicly traded companies from which individual investors get to choose.

Key is competition?

Last year, there were 858 private equity buyouts of U.S.-based companies, up 62% from the 531 in 2004, says Dealogic. In 75 of those cases last year, the private equity firm took a public company off the market, up from 60 in 2004.

That is one reason the overall number of public companies listed on the New York Stock Exchange and Nasdaq Stock Market last year fell by 53 to 5,983.

Proponents say private equity firms help keep U.S. businesses more competitive. The threat of being bought out keeps CEOs motivated and looking to boost returns, says Lewis Freeman, director of corporate turnaround firm Lewis B. Freeman & Partners. "The private equity firms do (to companies) exactly what you do when you get divorced after 20 years," he says. "You ... get rid of all the fat."

And there are successes. Consider VeriFone, which makes the boxes for cash registers to process credit cards. The company lost money as a unit of Hewlett-Packard, says Alec Gores, chairman of Gores Technology, the private equity firm that bought VeriFone in 2001. By focusing sales staff on selling VeriFone products, not computers, things were turned around. "HP could have done the same thing if they decided it was a core business," Gores says.

Gores sold VeriFone in 2002 to another private equity firm, GTCR Golder Rauner, for an undisclosed sum. GTCR took VeriFone public in April 2005. By the end of its fiscal year in October 2005, the company had $485 million in annual revenue — up 64% from fiscal 2002. Its stock has more than doubled.

Fees a concern

One common complaint is the fees some private equity firms charge and how they insure their payouts by loading debt on the companies they buy, says Bill Parish of investment management firm Parish & Co. He calls the fees scandalous. One of his criticisms is with a fee called "the carry." In a recent proposal to the Oregon pension plan, for instance, Texas Pacific revealed it would get the first 20% of any cash generated by an investment after the other partners' initial investment was returned, Parish says.

But that cash doesn't necessarily have to be the result of the companies in the portfolios doing well, Parish says. A private equity firm can have a company in its portfolio take out a loan and use the proceeds from that loan to pay the carry upfront. Then the private equity firm can lock in its payment no matter how the investment ends up turning out for the other partners, Parish says.

Robert Schwenkel, head of the private equity group at law firm Fried Frank, says that characterization of the carry is an oversimplification. He says, in most cases, private equity firms do not collect the carry until they sell an investment for a profit and return the investors' original investment. Only then can the private equity firm take 20% of the remaining profit.

Others are peeved at the fees private equity companies pay themselves. In May, rock band Linkin Park threatened to stop making music because members were outraged that out of the $600 million raised by the IPO of its label, Warner Music, just $7 million — roughly 1% — would go to Warner. Most of the proceeds were used to pay dividends to private equity investors such as Bain Capital and Thomas H. Lee Partners and to repay some of the debt that was piled on. By the time of the IPO, company insiders and executives had received more than $800 million in bonuses and dividends, while the company still had $2.2 billion in debt, according to IPOhome.

Some investors have refused to play along anymore, says Francis Gaskins, editor of Paper products company Boise Cascade filed to go public in February 2005 but was forced to withdraw its plans just three months later. Investors didn't like that $2.4 billion in debt was piled onto the company by private equity owner Madison Dearborn Partners, Gaskins says, and that the entire $288 million from its IPO was earmarked to pay insiders, including private equity investor Madison Dearborn.

Despite the controversy, though, Allan Holt, co-head of the U.S. buyout group of Carlyle Group, says in the end private equity companies are just another set of investors "looking for opportunities." He says private equity investments will create more opportunities for public investors as the companies go full circle and return as IPOs.

Will the boom continue? That depends on whether the perfect setting for private equity continues, says Fentress Seagroves, partner in PricewaterhouseCoopers' transaction services unit.

With more private equity firms bidding for companies, prices are rising, making it harder to make a big return, Seagroves says. Meanwhile, there's always a threat banks will charge higher rates for the borrowed money on which private equity thrives, eating further into returns. If returns aren't there, investors won't be either. If the easy money is pulled away, the only private equity firms to survive will be the ones that don't "miss a beat," Seagroves says.

Bill Parish
Parish & Company
10260 SW Greenburg Rd., Suite 400
Portland, OR  97223
Tel:  503-643-6999  Fax: 503-221-3161

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