Private Equity's Surprising Slowdown

It may look like private equity firms are taking over the M&A field, but the rising stock market could put them at a competitive disadvantage

It might seem, based on the financial headlines of the last year, that private equity firms have gained unlimited power in the world of corporate mergers and acquisitions. Private equity funds smashed one record after another in 2006, raising more cash, doing more deals, and taking a larger piece of the M&A market than ever before. Private equity accounted for nearly 20% of all global M&A in 2006, compared to just 4% during the previous M&A market peak, in 2000 (see, 12/28/06, "Private Equity's Big Winners").

Just five weeks into the year, however, there's evidence that the balance of power in the financial world may be tilting away from private equity players and back into the hands of large, publicly held corporations. New data from market researcher Dealogic yields several surprising results. Private equity firms, also known as "financial sponsors" in the deal world, account for just 10% of the deals announced for the year to date, according to Dealogic. That's down from 18% for the full year of 2006 and closer to the recent norm. Private equity accounted for 12% of deals in 2005 and 13% of deals in 2004.

The new data also provides some evidence that corporations, known as "strategic" buyers, are making a comeback. Publicly held companies can use their stock to buy other companies—something that privately held financial sponsors can't do. The number of stock-only transactions has spiked since the beginning of the year. Stock transactions account for 25% of deal volume so far this year, compared to 14% of deal volume at this time last year and 15% for all of 2006.

Losing Leverage

The shift in power is related to the rising value of the stock market. Corporate profits are strong, inflation and interest rates are under control and the price of oil and other commodities is falling, pushing stocks higher. The Dow Jones industrial average hit an all-time intraday high over 12,700 on Wednesday, and the Standard & Poor's 500 hit its highest level in six years (see, 2/7/07, "Stocks Edge Up Amid Solid Data, Oil Drop").

A strong stock market makes it more difficult for private equity players to win deals. They must pay for their acquisitions with a combination of cash and debt. Their charter rules prevent them from putting too much cash into a deal, and banks and other lenders set limits on the amount of debt they will lend for a particular deal. It's usually 9 to 12 times earnings before interest, taxes, depreciation, and amortization, or EBITDA. If stocks are trading at that level in the public market, it's hard for a private equity player to step in and pay a premium. But publicly held strategic buyers can use their stock to pay a higher price.

That's why private equity firms are losing a bit of leverage so far this year. "Financial sponsors dominated the headlines last year, accounting for a record percentage of all deals. This year, we're going to see strategic buyers win more deals since financial sponsors will get priced out of the rising equity markets," says Boon Sim, head of Americas M&A at Credit Suisse (CS).

Still Strong

Overall, there have been fewer deals this year to date than at the same point last year, although the total value of deals is rising. In other words, the early part of this year has been characterized by a shift to fewer but larger deals. That's consistent with a shift toward strategic buyers, who tend to make fewer acquisitions than private investors. There have been 2,532 deals worth a total of $388.2 billion announced so far this year, down from 3,317 deals worth $323.7 billion announced at the comparable point of 2006, according to Dealogic. The number of deals has declined 25% while the volume, or aggregate value, has increased 20%.

This doesn't mean that private equity is in trouble. It remains incredibly robust, and will continue to win lots of deals. On Feb. 2, private equity leader The Blackstone Group beat out publicly traded Vornado (VNO) in a bidding war for Equity Office Properties Trust (see, 2/8/07, "At Last, Blackstone Bags Equity Office"). Blackstone won with a bid of $38.9 billion, the largest leveraged buyout in history. Vornado bid more than $40 billion, but Equity Office (EOP) took the lower offer because it preferred cash (see, 1/11/07, "A Brewing Battle for Equity Office?").

There have been plenty of high-profile all-stock deals, too. On Feb. 5, State Street Corp. (STT) offered $4.4 billion for Investors Financial Services (IFIN). And there have been cases where boards have simply turned private investors away. Cablevision (CVC) has turned down a management-led buyout offer, and shareholders are increasingly unsure about whether to approve a takeout of media company Clear Channel Communications (CCU).

Sea Change?

If the trend continues, strategic buyers have the power to shift M&A valuations much higher. "It's not necessarily a good thing. All-stock transactions tend to be overpriced," says Phillip Phan, a professor of management at the Lally School of Management at Rensselaer Polytechnic Institute in Troy, N.Y.

The year is young, and the data could shift as the year continues. But the magnitude of the slowdown in M&A and deals with financial sponsoring is significant. While private equity is probably headed for another strong year, it might not run the table the way it did last year (see, 12/18/06, "Deals of the Year, in a Year of Deals").