A Private-Equity Peak?

By Janet Morrissey

Private-Equity players such as Cerberus Capital Management and Kohlberg Kravis Roberts have scored some of the biggest buyouts ever in recent months, including TXU, First Data Corp. and Chrysler. But are these cash-heavy private-equity (PE) firms racing against time? They need to win and ink future deals before the leveraged-buyout (LBO) window slams shut--a scenario Wall Street experts are betting will happen sooner rather than later.

That's one reason some private-equity players are going public, such as Blackstone Group and Fortress Investment Group. Others are resorting to deal jumping--busting in on another firm's deal with a higher bid, as Filmore Capital Partners did to Formation Capital in the Genesis Healthcare takeout. "There has never been a buyout market that has been this frothy," says Thomas Roberts, partner at Weil, Gotshal & Manges, a leading mergers and acquisitions (M&A) law firm. "[The cycle] looks like it's at the top."

The volume of M&A deals in the U.S. alone surged to $1.49 trillion in 2006--a level not seen since the tech boom in the late 1990s, when annual activity topped the $1.5 trillion mark just prior to the dotcom crash, according to market-research group Dealogic. And it's only halftime. Through early July, M&A volume totaled $1.17 trillion, up from $761.5 billion during the same period a year ago, the first time that M&A volume has topped the $1 trillion mark in the first six months of a year. Private equity accounted for about 35% of total M&A activity so far in 2007, up from 22% last year.

The magnitude of deals-- in volume and size--is unprecedented, said Andrew Nussbaum, a partner at Wachtell, Lipton, Rosen & Katz, which has represented such firms as Apollo Management and Starwood Capital in LBO transactions. "There are many buyers for practically every seller," he said. All this has left private-equity players scrambling to find the next deal while they're still flush.

One sign of the frenzy is deal jumping. In the past, such a tactic was rare in the private-equity club. Historically, going-private transactions were bumped only when a strategic buyer jumped in, such as Whirlpool Corp. against Ripplewood in the Maytag contest, or Building Materials Corp. of America's attempt to bust up the Carlyle Group's buyout of ElkCorp. For PE investors deal jumping was considered a faux pas. "It has long been suspected that there is an unwritten gentleman's agreement among private-equity firms to refrain from jumping each other's deals," said Chris Young, director of M&A research at Institutional Shareholder Services, a highly regarded independent proxy-advisory firm.

PE firms are starting to defy this unspoken rule. A team of PE players joined forces with publicly held Vornado Realty earlier this year to try to derail Blackstone's agreement to buy office giant Equity Office Properties Trust. Although the PE contingent, which included Starwood and Walton Street Capital, eventually dropped out, the ensuing bidding war wound up costing Blackstone significantly more to buy Equity Office in what became the largest leveraged buyout in Street history. Blackstone was forced to boost its bid to $55.50 a share, or $39 billion, from the original $48.50 a share. Another deal jumper: an affiliate of Apollo Management challenged a bid to take EGL private with a counteroffer that has driven up EGL shares more than 50% and added more than $750 million to the original takeover price.

Young predicts deal jumping will become even more common as takeover candidates become scarcer. "Eventually there's going to be fewer and fewer targets," he said. And when that happens, it could get nasty. "Private-equity firms still have a lot of powder to burn, and they're going to have to start being more competitive, and we'll potentially see more deal jumps."

Fueling the competition further are disgruntled mainstream investment funds, which have been egging on PE firms to deal jump. Some have become quite vocal and even threatened to vote their shares against a deal unless a bidder kicked in more money. One such firm is Cohen & Steers Inc., a nonactivist real estate investor, which publicly criticized Blackstone's original takeover offer for Equity Office as being ridiculously low. The firm's comments helped trigger the bidding war that ensued.

Bob Steers, the firm's co-CEO, won't shy from speaking up when he feels a takeout isn't fair. "Oh, absolutely," he said. "Our fiduciary obligation is to maximize the returns and the valuation for our investors." Carl Icahn more recently suffered a similar predicament when shareholders rebelled against his offer for auto-parts maker Lear Corp., forcing him to cough up more cash. And several PE financings have flopped because investors balked at the lenient loan terms.

How much longer can the boom last? "I do think the market has gotten away from itself," said Roberts. "It's inevitable it will slow down, and there will be some reversals." Banks and law firms have been quietly beefing up their distressed-trading desks over the past six months. The end is near, but it could be profitable.