By Steven Pearlstein
Wednesday, January 11, 2006

It's a wonderful time to be in the private equity business.

Equity investors are throwing money at you, led by pension funds, who are desperate to show an 8 percent return in a 5 percent world. Last year, private equity firms raised a record $250 billion around the world, with Blackstone Group about to close on a new $13 billion fund, the biggest ever.

Banks and hedge funds are knocking on your door with gobs of cheap credit on easy terms. Forget about junk bonds, which are so 1980s and provided a mere $95 billion toward corporate finance last year. The hot new source of financing is the "leveraged loan" market, which hit a record $500 billion in new issues last year, most of it for leveraged buyouts, according to Loan Pricing Corp., an independent pricing service. "Leveraged" is the name for bank loans to highly indebted companies. They are usually broken into pieces and sold to hedge funds and other banks.

Of course, nothing juices a private equity firm more than deal flow, and these days, there's a gusher. Worldwide, there were $259 billion worth of leveraged buyouts last year, up 58 percent from 2004, according to Citigroup. And the average deal is getting bigger. Five years ago, there were 18 such deals valued at more than $1 billion. Last year there were 114, including four topping $10 billion.

It's common knowledge that the deals generate big fees for investment bankers. But did you know that the acquired company also pays transaction fees to the private equity firms, typically 1 to 2 percent of the value of a transaction, split between the private equity firms and their investors? They are not a reason to do a bad deal, but they sure sweeten the taste of mediocre one.

Last year was also the year of big scores, with some private equity investors cashing in on huge short-term profits.

KKR led a group that bought Texas Genco, a Houston-based power generator, for $3.9 billion, and sold it barely a year later for $8.3 billion, a six-fold return on its equity. And just this week, Washington-based Carlyle Group learned that it could realize a ninefold increase on its three year-old investment in QinetiQ Group, a British defense technology firm, when the former government-owned company is taken public next month.

In those deals, as in many others, buyout firms have been able to get much of their original investment back quickly by having the company borrow even more money to pay out a special "dividend" to the new owners. By one estimate, these "dividend recapitalizations" accounted for half of the profits earned by private equity firms last year.

If all this sounds too good to last, it probably is, as some of the more senior private equity managers privately acknowledged this week. They don't use the b-word, but a bubble is just what it is.

Let's start with the inflated prices being paid for companies. For many years, the rule of thumb was six or seven times EBITDA, the acquired company's earnings before interest payments, taxes, depreciation and amortization. Today, sale prices often run to 8 or 9 times EBITDA.

Traditionally these buyouts involve private companies, or divisions spun off from larger public companies. But lately, private equity firms have going after publicly traded companies with offers up to 30 percent above the price set by the stock market, just as Carlyle did this week with its purchase of WaterPik Technologies.

Even more worrisome is the level of debt taken on to finance the deals. Not long ago, 70 percent leverage was the norm, with total debt typically 4 to 5 times EBITDA. Today, it's not unusual to find 85 percent of a deal financed with debt, with overall debt levels of 6 to 7 times EBITDA.

That high leverage allows private equity firms to realize those big returns on their equity when things go well. But it also leaves companies so saddled with debt they may not be able to invest in new equipment or products, or absorb the business shocks that inevitably come along. Perhaps that is why a survey of London financiers last month found that 95 percent agreed buyout debt had reached "dangerous and unsustainable levels."

We know from past experience that bubbles can persist for quite some time -- in the case of leveraged buyouts, as long as interest rates stay low, investors remain willing to accept ever-falling returns and the egos of private equity managers are inflated by the size of last year's bonuses.

But at some point -- my guess is about a year from now-- a top firm will find itself unable to finance a deal, or a big public pension fund will announce that it is reducing its commitment to private equity -- and everyone will see that as the long-awaited signal to head for the exits. And that's precisely when it will be too late.

Steven Pearlstein will host a web discussion today at 11 a.m. at washingtonpost.com. He can be reached at pearlsteins@washpost.com.