Investors: You can’t count on private equity to bail you out

Feb 23, 2011

Four years ago, Fortune put the Blackstone Group's boss, Stephen Schwarzman, on its cover, dubbing him the "King of Wall Street." He was the personification of how private equity had come to dominate mergers and acquisitions, and few weeks seemed to pass without private equity firms agreeing to buy one of corporate America's most recognizable brands, typically for more than the company had been worth. The hype became so intoxicating that one newspaper suggested that the barbarians might next approach Microsoft's gates.

But Schwarzman et al. were never actually able to afford a company with a $260 billion market cap like Microsoft's. Private equity, like everything else, had its limits. And those limits have only tightened in the intervening years, largely because of that era's excesses. Today's private equity firms still can't afford Microsoft (msft), but they also are unable to buy dozens of other large companies that were once within their reach. It's a significant loss of clout that shows no sign of abating, and the big losers are those with megacap stocks in their portfolios. No longer can such folks buy, hold, and wait to be cashed out by free-spending financial sponsors.<!-- more -->

Here's how private equity works: Firms invest out of "funds," or pools of capital raised from institutions like public pensions, college endowments, and private foundations. It's similar to the way hedge funds are raised, except that PE fund investors are not allowed to withdraw their capital on demand (which is why you didn't hear about PE funds collapsing during the financial crisis). Instead, they get to voice their approval or disapproval every three to five years, when the firms return to raise more money. (Of late they've been saying, "Whoa there, big fellas!")

A consensus has emerged that the largest private equity funds no longer return enough bang for the buck. A recent survey of such investors by Coller Capital found that only a third of respondents considered big North American buyouts a strong area of investment over the next two years; prospects in Europe and Asia fared even worse. Optimistic expectations more than doubled, however, for mid-market ($200 million to $999 million) and small-market (less than $200 million) deals in all three regions.

Consequently, some of the industry's best-known names have encountered difficulties fundraising. Blackstone (bx), for example, raised around $15 billion for its most recent private equity fund, despite having secured $24 billion the last time around. Rival firm Kohlberg Kravis Roberts (kkr) soon will begin marketing its next North American fund, but it's unlikely to get much more than half of the $18 billion it raised five years ago.

So what can't private equity buy today that it could four years ago? To figure that out, we can add up the amount of equity the seven largest funds could contribute, were they all to work together (which they have done). This comes out to $11.6 billion. We then tack on "leveraged financing," since no big buyout is being done without a heaping helping of debt. Standard & Poor's LDC reports that PE deals larger than $1 billion used 39.28% of leverage last year, so that works out to approximately $29.5 billion (equity+debt).

To be clear, that is an extremely high ceiling and does not account for continued deterioration in fundraising or current debt availability. A more practical calculation might fall as low as $18 billion. But $29.5 billion is our take-it-to-the-bank figure. And, as of this writing, it puts 174 U.S.-listed companies with bigger market caps out of range for private equity. That's more than twice the number of companies private equity firms couldn't buy when Schwarzman was on our cover, based on a similar calculation.

Microsoft remains among today's forbidden fruit, alongside companies like Boeing (ba), CVS Caremark (cvs), Home Depot (hd), Oracle (orcl), and UnitedHealth (unh). Those on the edge include Praxair (px) and PNC Financial Services (dow).

This means that those companies' shareholders must now content themselves with hefty dividends and steady revenue growth. Private equity is basically stuck outside the gate.

A previous version of this story incorrectly calculated the maximum deal total as $41.1 billion, due to a double-counting of the equity. Our apologies for the error.

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