Buyout firms: pain today, gain tomorrow

LONDON (CNNMoney.com) -- The private equity business may be in the midst of a slowdown, but buyout firms are likely to benefit as tougher market conditions force them to train a sharper eye on which companies they buy, according to an industry study.

It's a dicey time. A debt crunch has brought new buyout activity to a halt, and private equity firms are hunkering down as they face the task of renegotiating $400 billion worth of deals they inked during the peak of the buyout boom.

On Wednesday, the buyers of college loan provider Sallie Mae (Charts, Fortune 500) said they don't intend to follow through with the $25 billion deal as it currently stands. Private equity firm J.C. Flowers and the banks underwriting the deal, Bank of America (Charts, Fortune 500) and JPMorgan Chase (Charts, Fortune 500), want out because looming new cuts in government subsidies for student loans could hurt Sallie Mae's financial performance.

The Sallie Mae deal is just one example of how the end of the easy-money era is changing the private equity landscape. In the future, firms will be more selective when they choose their takeover targets, according to a new report by consulting firm Ernst & Young, which receives business from private equity firms.

The tightening of credit will put pressure on financing deals, but "this environment may prompt a more conservative approach with an increasing need for deal diligence at acquisition," the report said.

If buyers become choosier, they may cut back on their activity and pump less money into deals - removing a key driver of merger activity.

But the report predicts that private equity will be able to weather the changes in the environment and keep driving returns at the companies they take over.

"Although the credit squeeze in 2007 may reduce the benefits from leverage and enhance the importance of underlying profit growth, private equity will continue to be an important factor in the world's financial markets," Ernst & Young said.

Private equity firms buy companies with the aim of overhauling their businesses and selling them at a profit or taking them public, usually within three to five years.

During the height of the buyout frenzy, private equity firms - armed with loads of cheap money - were willing to pay sky-high prices for their takeover targets. But some of the businesses they agreed to buy aren't looking as attractive now.

The Sallie Mae buyout isn't the only deal fiasco. Last week, Kohlberg Kravis Roberts and the private equity arm of Goldman Sachs (Charts, Fortune 500) said they no longer intend to complete their deal to buy audio equipment maker Harman International Industries (Charts) due to changes in the company's business.

The large amount of deals that are waiting to close have challenged private equity firms as financing has been harder to come by. New deals have also been put on hold. Deal activity in the United States fell to $4.2 billion in August, down 68 percent from the same month last year, according to Thomson Financial.