Who gets hurt after the buyout boom

The deal machine keeps humming along, but investors may get scathed when the private equity party ends.

By Grace Wong, CNNMoney.com staff writer

NEW YORK (CNNMoney.com) -- Private equity buyouts keep breaking records, raising concerns that the buyout boom may be near a peak - and that investors will get hurt when the party comes to an end.

Utility firm TXU Corp. (Charts) said Monday it agreed to be bought by Kohlberg Kravis Roberts, Texas Pacific Group and the private equity arm of Goldman Sachs (Charts) for $32 billion, or nearly $45 billion including assumed debt, making it the biggest buyout ever.

Is the private equity buyout boom good for individual investors?
  • Yes
  • No
  • Makes no difference
  • Not sure

The move comes just weeks after Blackstone Group put together what was then the biggest buyout deal when it finalized its $39 billion takeover of Equity Office earlier this month - $23 billion in cash and $16 billion in assumed debt.

Deal sizes aren't the only records being smashed in the current private equity boom. Fundraising has also ballooned, hitting a record $200 billion last year. (Check out the latest figures from the industry's power players here.)

So-called limited partners - the pension funds, endowments and other institutional investors who invest in private equity - have poured billions into the buyout funds in the pursuit of big returns.

In the 12 months through last September, investments in buyout firms returned 23.6 percent versus 9.7 percent for the S&P 500, according to Thomson Financial.

But buyout firms face growing competition for deals, which can result in higher prices, and that has historically led to lower returns, according to Steven Kaplan, a finance professor at the University of Chicago Graduate School of Business.

During the last buyout craze of the late 1980s, private equity firms were gushing with money and paying ever-higher prices for deals.

The biggest takeover of that era, KKR's $31 billion buyout of RJR Nabisco, which included debt - a deal chronicled in the well known book "Barbarians at the Gate" - became a nightmare and reportedly resulted in nearly $1 billion in losses for its investors.

To be sure, there are key differences between the current cycle and the last private equity boom.

For one, more and more firms tired of operating under the glare of the public spotlight are rolling out the welcoming mat for the investors who would take them private.

"There is much more demand for private equity than in the past. Demand comes from the fact that [more] public companies don't want to be public," Kaplan said. (Why it pays to be private.)

And while a wash of cheap money fueled both the latest boom cycle and that of the late '80s, the growth of sophisticated instruments like credit derivatives has helped lower the risk for investors this time around, some experts say.

"Now there is a huge secondary market for selling off credit risk, so buyers can buy a junk bond and if they don't want to expose themselves to the default risk they can sell the contract to someone who has to compensate them if the bond does default," said Jay Ritter, a professor of finance at the University of Florida.

While new tools may improve risk management, some argue that default risks eventually will rise from their historically low levels.

A recent study by Moody's Investors Service predicts that defaults on corporate debt will rise - and that the tide in the credit markets will turn before the end of the year.

Booms and busts will always occur, according to Sheryl Schwartz, managing director of alternative investments at retirement fund firm TIAA-CREF.

But she said via e-mail that she's prepared for a downturn by having a diversified portfolio and by teaming up with buyout partners that have raised and exited funds in other down cycles.

"Overall, yes, we are concerned that returns will start to decline, but feel the best managers will still outperform public equities in the long term because they are disciplined buyers and sellers and add value to companies they invest in," she said.

Private money

Wall Street's man of the moment Top of page