Prospecting for Private Equity Targets

The flood of cash has private equity investors surveying the full corporate landscape for buyout candidateswhere will they shop next?

For investors and companies who may wish to go private, the rise of private equity offers an array of allures. A leveraged buyout can represent a healthy premium for shareholders. Company executives can shed many of the regulatory burdens public companies bear. Top managers also typically enjoy richer paychecks in the private market.

Those groups of private investors, using large amounts of borrowed money, buy companies with an eye toward improving them for sale. Indeed, private equity funds enjoyed a record year in 2006 (see, 12/28/06, "Private Equity's Big Winners"). And they have assumed a place in nearly every potential deal when a company is in play.

The Right Numbers

So which companies are likely to be acquired? Private equity investors certainly won't tip their hands. But it's possible to field a list of likely targets, based on an analysis of industrial sectors and individual companies.

"Private equity firms like companies with stable cash flows, low debt levels, and cheap stock prices," says Scott Marchakitus, a Goldman Sachs Group (GS) credit analyst who covers media, telecom, and cable companies.

Private equity buyers generally seek targets with an internal rate of return (IRR) of 20% or more, according to Marchakitus. The IRR, which takes into account the present value of future profits, can be as low as 15% in some cases where noncore assets can be sold to raise cash.

Goldman chief sector strategist David Kostin and U.S. credit strategist Charles Himmelberg issued a report on Mar. 22 examining the appeal of 937 potential U.S. buyout targets. The study ranks the companies based on their IRR, using Goldman's proprietary methods. The credit analysts worked with equity analysts to understand the potential for cost cuts and asset sales, which can boost returns. The report identified some companies like Minnesota-based grocer SUPERVALU (SVU) with an IRR of more than 70%. It determined that pharmacy chain Rite Aid (RAD) has an IRR of more than 65%. That doesn't mean such companies will be acquired, but their financial profile and the nature of their business could arouse interest.

Tech Plays

To assess where the next private equity deal may occur, it helps to know a bit about how private equity firms operate. They typically buy companies at a low price and pile substantial debt, or "leverage," onto the acquisition target's balance sheet. Debt boosts a deal's return, because the borrowed cash can be returned to investors in the form of a dividend. Stable cash flows are necessary to pay down the additional debt. Companies with a battered stock price and slow-growth prospects are usually deemed suitable, as long as the enterprise sports stable cash flows. Some private equity investors focus less on such financial engineering and pay more attention to boosting return through changes in cost structure, operations, management, or strategy.

Certain industry sectors lend themselves to leveraged buyouts. Consumer products, retail, and health care often make good LBOs because revenues usually remain stable despite fluctuations in the economic cycle. Even when times are tough and people trim their spending, most of us still need to buy razor blades, shoes, and groceries and must visit the doctor. Potential retail buyouts include electronics retailer Circuit City Stores (CC) and health-care services company AmerisourceBergen (ABC). Goldman says its research indicates that both companies have IRRs well in excess of 70%.

Tech sectors such as software and IT services are increasingly popular with buyout firms, too, because their wares are business necessities in good times or bad. Tech firms also have turned themselves into service companies that win big contracts that can produce stable revenues for several years. Private equity buyers often win deals because the number of strategic buyers has been reduced over the years as companies such as Oracle (ORCL) acquired midsize to large companies, says Peter Falvey, co-founder and managing director of Revolution Partners, a tech-oriented investment bank.

"Private equity buyers have stepped in as the pool of strategic buyers has shrunk," Falvey says. Tech is filled with potential takeout targets such as chipmaker Ingram Micro (IM) and IT services company Unisys (UIS), both of which have an IRR in excess of 60%, according to Goldman.

Real Estate and Energy, Too

Real estate is another favorite sector for private equity investors. Blackstone Group's buyout of Executive Office Properties Trust is a good indication of interest in the sector (see, 12/19/06, "Deal of the Year, in a Year of Deals"). "Real estate typically fits better in a private equity model than a public model because the public markets value the delivery of consistent earnings, and creating value in real estate requires the diversion of cash from earnings to reinvestments in the property," says Jeffrey Giller, managing principal of Liquid Realty Partners. Liquid Realty is a private equity fund manager that buys limited partners' interests in other real estate funds.

Potential real estate takeouts include CB Richard Ellis Group (CBG), a Southern California-based real estate company that Goldman says has an IRR of more than 70%.

Private equity firms also have been moving into the energy sector. Demand for oil has been strong, thanks to growing demand from China, India, and other developing markets. One oil company with buyout potential may be Sunoco (SUN), a company with an IRR Goldman calculates at more than 70%.

Less Likely Targets

Certain sectors are considered less favorable for LBOs. The industrial and auto sectors tend to swing too wildly with the economy, and telecom services tend to be complicated by regulatory oversight and high capital costs, according to Marchakitus. LBOs do occur in those sectors, although they tend to be less common than LBOs in other sectors.

Goldman determined that a Sprint Nextel (S) buyout could have a higher-than-expected return of 30%. Of course, that doesn't mean a deal is likely. IRR isn't the only factor in a buyout. In Sprint Nextel's case, the size of the company reduces the probability of a deal, Marchakitus says (see, 3/23/07, "Why $80 Billion for Sprint May Make Sense").

More likely: a buyout of Alltel (AT), a midsize wireless company that has put itself on the block. The company operates in many rural markets, which means it doesn't face as much competition as some larger rivals. It has little debt on its balance sheet, which makes it attractive to buyers. The biggest obstacle? Price. Alltel shares have soared from the low $50s last year to $62 as of Mar. 27.

The media sector will also continue to draw interest from private equity investors. While the business is under pressure from new rivals on the Internet, it still generates plentiful cash. The biggest obstacle is that many media companies such as News Corp. (NWS), Viacom (VIA), and The New York Times Co. (NYT) are run by families that hold shares with special voting rights. That's why Marchakitus and other experts think CBS (CBS) might make a good buyout target. It's controlled by Sumner Redstone, as is Viacom. But Redstone may be more agreeable to selling CBS because Viacom "seems to be his passion," Marchakitus says. Private equity investors may have a strong interest in CBS, given their proposed takeover of Clear Channel Communications (CCU), which has similar businesses.

Cash to Burn

In February, the Blackstone Group led a buyout of Equity Office Properties (EOP) for a then-record $36 billion, only to be topped weeks later as Texas Pacific Group and other firms offered $45 billion for Texas power company TXU Corp. (TXU) (see, 2/26/07, "How Green Green-Lighted the TXU Deal").

Some experts believe the buyout binge could continue for several years, because private equity funds are loaded with $300 billion in cash. Since they can borrow at least several dollars for every dollar of their own, global private equity has the capacity to fund $1.3 trillion worth of transactions, according to Goldman's research. Goldman itself is already one of the world's largest private equity players, with $39 billion in assets under management. On Tuesday, the firm announced that it would push deeper into private equity, raising a new fund with an estimated value of $20 billion.

True, there's no guarantee that any particular company will be acquired. But the private equity boom is expected to last for some time, and the companies with the most alluring returns naturally make the best targets.

Click here to see a slide show of the most promising buyout candidates.

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