Rising rates threaten the buyout boom

LONDON (CNNMoney.com) -- Stephen Schwarzman, CEO of the Blackstone Group, took home nearly $400 million in pay last year and stands to reap billions when his firm goes public - a reflection of the booming success of private equity firms.

But the favorable conditions that have lined the pockets of Schwarzman and other kings of the buyout business are running into headwinds.

For years, Blackstone and other private equity firms - which have become the new face of dealmaking on Wall Street - have basked in an era of cheap money and low interest rates. But turmoil in the Treasury bond market is raising worries that this golden age may be coming to an end.

Bond prices from Tokyo to Frankfurt to New York have sold off in recent weeks amid concerns that interest rates are marching higher worldwide. That's pushed up bond yields and fueled worries that it will be harder to borrow money. Bond prices and yields move in opposite directions.

"This is the end of the cheap money cycle," said Marc Pado, U.S. market strategist at Cantor Fitzgerald.

In the United States, the yield on the benchmark 10-year Treasury note has kept pushing higher since it eclipsed the key 5 percent level last week. Early Tuesday, the yield was around 5.21 percent, up from 4.88 percent just two weeks ago.

Analysts say the rise in bond yields means bond investors are finally coming to terms with big changes in the global economy - such as rising commodity prices and rising labor costs in former low-cost countries like China - and many expect long-term yields to keep heading higher.

PIMCO manager Bill Gross, a longtime bull on bonds, has even revised his outlook for the market and now expects the 10-year Treasury yield to rise as high as 6.5 percent in the next three to five years.

Economists say years of strong growth in countries like China and India, where labor costs are low, have helped keep inflation contained. But as these engines of the global economy keep charging ahead, it will be harder for them to keep inflation in check.

"Real rates are firming because the global picture is getting better. On top of that, the inflation outlook continues to be uncertain, and if anything - is getting worse," said Pierre Ellis, global economist at Decision Economics in New York.

Growth outside of the United States is strengthening and countries that have long used monetary policy to stimulate their economy are starting to back away from easy money.

Among those likely to get hit by tighter credit? Buyout firms, which use little of their own money to acquire companies, borrowing heavily to do deals.

Artificially low interest rates over the past couple of years have allowed some private equity firms to make a profit by simply piling on loads of debt on to the companies they buy.

But now that situation has changed, says Pete Hahn, a fellow at Cass Business School in London and former managing director of corporate finance at Citigroup. "Interest rates appear to be more reflective of economic reality, and decisions aren't as easy as they were yesterday," he said.

Rising interest rates could also slow the amount of money coursing through private equity. Big investors like pension funds have invested billions in private equity in search of a high yield. But now some of these investors may reevaluate where the opportunities really are, Hahn said.

Private equity deals have become a driving force in the merger business. So far this year, private equity transactions have accounted for about a quarter of the $2.3 trillion of worldwide deal activity, according to Thomson Financial. By comparison, private equity deals only accounted for 10 percent of global deal volume in 2002.

They've also been a key source of support for stocks on Wall Street. When a buyout firm takes a company private, it decreases the number of shares available in the public market, thereby raising prices for the shares remaining.

Rising borrowing costs could put pressure on private equity at a time when industry professionals are already concerned about overpaying for deals. Competition for deals has grown intense, and criticism from shareholders at target companies has also pushed up offer prices in some instances.

A private equity group made up of Blackstone, Goldman Sachs Capital Partners, Kohlberg Kravis Roberts and TPG was the latest to buckle under shareholder pressure. Last week, the group sweetened its offer for artificial joint maker Biomet (Charts) to $11.4 billion, up almost 5 percent from its original bid of $10.9 billion.

But while credit may start to tighten, it'll take more than a gradual rise in rates to derail the juggernaut that is private equity, analysts said.

"Higher rates will slow that tide but that is a very strong tide right now and not one that's going to turn on a dime unless something changes dramatically," Pado said.