Private equity funds The Locusts Return

Private equity funds, which made a killing on the back of cheap credit before the financial crisis, are regrouping as global financial conditions edge toward those of the pre-2008 boom years.
Like a locust, private equity firms in the past have attacked in swarms and eaten entire sectors bare.

It’s been ten years since Franz Müntefering, the chairman of Germany’s center-left Social Democratic Party, used the term “locust” to describe financial investors with short-term, profit-maximizing investment schemes.

He was taking particular aim at private equity funds. These are groups of investors who collect money from pension funds, insurance companies, government funds and wealthy families and then use it to buy controlling interests in companies.

At the same time, they leverage their investments with multiple loans and let their newly purchased companies carry the debt.

The objective of private equity investors is to make companies more profitable through better management, financial optimization and strategic acquisitions, and to then to resell the interest for the highest possible profit. If they’re successful, private equity funds play a beneficial role in the economy.

But in the private equity boom between 2006 and 2007 — just prior to the start of the global financial crisis — many funds shifted their strategy to making a fast buck.

It’s now even cheaper to obtain a loan than it was in the boom years before 2008.

They exploited the unlimited availability of cheap credit to leverage their capital equity and, after buying a company, quickly recovered their capital investment by forcing the new acquisition to pay dividends financed through credit. Such actions lent credence to Mr. Müntefering’s references to “locust,” a term that outraged investment bankers in 2005.

Globalization driven by capital markets was the reason behind the boom in the last decade. The script called for a final battle for supremacy on the world market with a handful of dominant companies in each industry emerging as winners.

Fueling the boom was a massive amount of credit, a result of years of low prime interest rates in the wake of the Internet bubble bursting and the terror attacks of September 11, 2001.

In this climate, private equity funds experienced an unprecedented blossoming. In 2006 and 2007, according to a market study by consulting firm Bain & Co., the funds drove takeovers totaling almost $700 billion (€625 billion) per year worldwide.

But during the economic crisis in 2008 and 2009, the volume collapsed to barely one-tenth of that amount.

The value of takeovers initiated by private equity funds has gradually recovered since then and in 2013 totaled $230 billion, which is near the levels of 2005, or the year of the locust. Investments in 2014 were probably considerably higher.

Is the next feeding frenzy starting? Conditions seem to be ideal.

The ingredients for a new private equity boom are already in place. And with them come the ingredients for another huge problem.

Disillusionment in the wake of the financial meltdown is disappearing. Important stock indices are storming from one record high to the next under ultra-loose monetary policies. Economic growth is increasing again in both Europe and the United States. Stock markets are receptive to initial stock offerings and globalization continues to progress rapidly.

Above all, it’s now even cheaper to obtain a loan than it was in the boom years before 2008. The mergers and acquisitions business is growing: The worldwide volume of announced takeovers and purchases is up by 40 percent to $3.4 billion, according to business data firm Thomson Reuters. This is almost the same amount as at the zenith of the Internet boom in 2000.

There are factors working against a private equity boom, of course. Companies learned from the crisis and have reduced their dependency on outside capital. It’s now less likely than in previous decades that firms lacking funds will seek a buyer to finance expansion.

In addition, many companies have now sold off subsidiaries not compatible with their strategic focus. And at the back of everyone’s minds is the threat of again being tarnished as “locusts.”

Nevertheless, there are more factors that speak in favor of a new private equity boom than against it. A lack of investment alternatives has swollen the cash reserves of equity funds. They already manage $3.8 trillion in capital with $1.2 trillion ready for investment. The pressure to invest is already driving takeover prices higher as companies go window shopping.

The ingredients for a new private equity boom are already in place. And with them come the ingredients for another huge problem. And that’s not good news for firms that could become targets of the investment funds.


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