Private Equity Players

Private equity groups are a fast-growing part of a vibrant mergers and acquisitions market.

May 2006 | by Ingrid Case

Cary Musech of Tonka Bay Equity Partners says that there’s more interest in private equity investments now because they are often outperforming the stock market.

Photograph by Kelly Rogers

“Companies view their equity now as being underpriced,” Engler says. That’s pushed the mergers and acquisitions market toward the cash deals offered by private equity firms.

New accounting rules are also making stock swaps less attractive options. Companies in a stock swap must now use purchase accounting instead of simply merging their balance sheets. That means they must value goodwill, or the difference between what they pay and the asset’s fair market value. “That’s a potential write-off against future earnings if the value of the business declines,” Engler says—and no one wants to see lower earnings.

Perhaps most importantly, private equity firms have found an ample supply of loans to supplement investor cash in deals. Banks are eager to offer loans because the economy is improving and because banks have seen their loan portfolios shrink as clients refinance, says Mike McFadden, managing director and a shareholder at Minneapolis-based private investment banking firm Goldsmith Agio Helms. In 2002, he says, a bank might have offered a private equity firm a loan equal to three to four times the earnings before interest, taxes, depreciation, and amortization (EBITDA) of the company to be acquired. Now many banks will consider multiples of five or six times EBITDA.

Success Breeds Change

The roaring private equity market has attracted money—and brought changes in how private equity firms operate, too. Increased competition has led some private equity firms to consider less profitable companies or to pay more for plum prospects. Both strategies lower return expectations. Some private equity groups are moving into industries such as retail that they might not have considered in the past. “Their return threshold has dropped, so they’re willing to look at more deals,” Monroe says. “They’re clamoring for the retail sector.”

Competition for deals has created a sellers’ market for companies with solid balance sheets and attractive prospects. That in turn has persuaded some companies to sell at auction, turning a careful courtship into a race to the gavel. “The private equity groups that don’t participate in auctions now are few and far between,” Monroe says. Auctions often result in higher selling prices, and they remove the negotiations that help private equity companies learn about a prospective acquisition. It’s more difficult for them to get information and spot problems when they buy companies at auction.