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For sure, private equity firms and their investors don’t make their investments out of the goodness of their hearts; they are looking for a return, typically a substantial one, on their investments. If they simply wanted stock market or fixed-income returns, they would invest in stocks or fixed-income securities. Most private equity deals, including venture capital deals, seek to earn a large return, either by harvesting profits from the companies they invest in, or by selling them at a better price at maturity or after a turnaround.
Private equity was made famous by the many so-called “corporate raiders” who emerged in the 1980s—Carl Icahn, T. Boone Pickens, Kirk Kerkorian, Saul Steinberg, and others. These investors would buy large stakes of a company, in some cases enough to get themselves or their own people on the board of directors, and push for change. If successful, and especially if they employed leverage by borrowing to help finance their purchase, they reaped enormous profits. But that strategy didn’t always work, as shown by the recent experience of Cerberus Capital Management, which bought Chrysler out of the Daimler-Chrysler merger only to put it into bankruptcy shortly afterward. More recently, Michael Dell teamed up with private equity investor Silver Lake Partners and certain other investors, including Microsoft, to buy Dell and take it private—such transactions and attempted transactions are not infrequent. Beyond Cerberus and Silver Lake, some of the larger names you’ll read about in the private equity space today include Kohlberg Kravis Roberts (KKR), Bain Capital, Warburg Pincus, the Carlyle Group, and the Blackstone Group.
Why You Should Care
Private equity is important—and has become more important—as a source of corporate capital over the years. More often than not a company that “goes public”—starts selling shares to the public to trade on a stock exchange—has gone through a considerable incubation in the hands of private equity. You should know that when that firm goes public, it’s a sign that the private equity firm has maximized its return on investment—which may not bode well for the company’s immediate future. Also, while private equity serves a useful purpose in rescuing failing companies (when successful), when that company is taken public again, it may not be the best time to buy. Finally, there have been some cases where firms have been bought strictly for the short-term gain of the individual or private equity firm, then plundered for their cash and assets. Watch carefully if you invest in—or work for—one of these firms.
74. LEVERAGED BUYOUT (LBO)
Want to sound suave and sophisticated at a cocktail party when the subject comes around to finance? Just mention the words “leveraged buyout.” A leveraged buyout is simply the purchase of a company by another company using “leverage,” or borrowed money.
What You Should Know
The acquiring company may be a company in the same industry, or it may be a conglomerate or holding company (like Warren Buffett’s Berkshire Hathaway), or a private equity firm specializing in LBOs. The borrowed money may come from traditional sources like banks or investment partnerships. Sometimes at least some of the money may come from the cash coffers of the company being acquired, and sometimes it may come from selling off some of the acquired company’s assets. Finally, the acquired company’s assets may be used as collateral on any debt issued to make the transaction. In some cases, an investment bank (see #28) might put together a consortium of lenders. Typically the debt ranges from 60 to 90 percent of the purchase price, and any debt issued in an LBO is considered high risk.
LBOs are more likely to be used when the acquired company has significant cash, stable cash flows, or quality “hard” assets that can be sold or used as loan collateral. Acquiring firms are often looking for good corporate assets in need of a turnaround, new management, or other operational improvements.
LBOs hit their stride in the 1980s, culminating with the $31 billion buyout of RJR Nabisco by LBO specialist KKR in 1989. The next big wave of LBOs hit during the 2005–2007 boom, with such names as Equity Office, Hertz, and Toys“R”Us being “taken out” by various acquirers.
More recently, leveraged buyout activity continues at a brisk pace because of relatively cheap borrowing rates, but no real big names have been “taken out.” Some have involved major parts of companies, such as a recent $4.8 billion buyout of DuPont’s auto paint business by the Carlyle Group.
Why You Should Care
LBOs have changed the corporate landscape, affording more companies more power to make more acquisitions, and cleaning the corporate “forest floor” of some companies past their prime. If you work for a company that is a target of an LBO, watch out; the acquiring company may look to streamline and trim assets (including you).
75. INSTITUTIONAL INVESTORS
Institutional investors are large organizations, public or private, that amass funds for an assortment of purposes and invest them in the markets. Their objective in most cases is to invest money on behalf of others, and their success is determined by market performance.
What You Should Know
The importance of institutional investors becomes clear when looking at some of the different types of institutions:
Pension funds are among the largest and most influential groups of institutional investors. Not surprisingly, their objective is to build assets to fund retirements of private and public employees, although today more private retirement savings plans (see #51 Retirement Plans) are self-directed, like 401(k) plans, and are thus more likely to come into the markets via mutual funds. In 2012, total worldwide pension fund holdings were estimated at $30 trillion, with 79 percent of that in the United States, the United Kingdom, and Japan.
Mutual funds are investment companies that invest on behalf of individual investors (see #70). Worldwide mutual fund assets totaled about $17 trillion in 2010.
Insurance companies invest assets—collected premiums—in the markets to achieve growth, pay insurance claims, and ultimately (if things go right) reduce the premiums. Insurance company investments are typically fairly stable, but in the wake of major disasters, insurance companies may sell sizable chunks of assets to pay claims, which can cause some short-term pain in the markets.
Sovereign wealth funds (SWFs) invest funds on behalf of their nations. Many such funds, like those in the Middle East, are simply investing surplus government reserves; some may also cover public pension obligations in their countries. One estimate puts the worldwide total at $5.2 trillion. SWFs made headlines for large investments in banks weakened by the economic crisis, but some SWF investments are a little more glittery—witness the 5.2 percent stake in Tiffany owned by the sovereign wealth fund of Qatar.
Other types of institutions include investment banks and trusts, and some refer to hedge funds and private equity as institutions.
Why You Should Care
Institutions still make up the lion’s share of stock, bond, and commodity investment in the markets. They weigh heavily on market performance and overall economic performance, and on the allocation of capital to public and private enterprises. Your fortunes in these markets will depend in part on what institutions are doing, and in some cases, like insurance investments, investment performance may affect your personal finances.
76. MONEY MARKET FUND
Money market funds (MMFs), or money market mutual funds, specialize in investing cash assets in short-term securities to provide investors with slightly higher returns than banks, and liquidity—that is, unrestricted deposits and withdrawals. As a place for investors to park short-term cash, which is then used by public and private enterprises to fund short-term operations, money market funds perform a vital role in the economy.