Debatable point: will this level of debt cause a collapse?

THERE'S no denying that private equity firms represent a crucial component in the mergers and acquisition world, but how does that translate to the rest of the economy--and is it a good thing?

While private equity can open up options for local firms and pump mega-dollars into the local economy, there are concerns that those dollars are not getting distributed widely enough and that the high amounts of debt used to finance these acquisitions eventually could threaten the region's economic health.

Background

Last week's reports that several private equity firms are considering a buyout of El Segundo-based Computer Sciences Corp. is only the latest example of private money being used to finance big transactions. Last month, Oaktree Capital Management announced that it was buying Sara Lee Corp.'s European operations. That followed Beverly Hills-based Platinum Equity's acquisition of computer modem maker U.S. Robotics Corp.

Actually, private equity has long played a role in the building of L.A.'s economy, stretching back more than 100 years to the fortunes amassed among many of the region's leading families, such as the Chandlers. But the concept of boutique firms really didn't take hold until the late 1980s. That's when Michael Milken and his Drexel Burnham Lambert operation in Beverly Hills popularized the use of high-yield or "junk" bonds as a source of funding for leveraged buyouts and corporate finance.

After Milken pleaded guilty to securities and disclosure violations in 1989, Drexel disbanded and Milken's proteges branched off to form their own private equity firms, including Leonard Green & Partners LP and Freeman Spogli & Co.

In the late 1990s, as the stock market took off and the dot-com bubble grew, venture capital firms, which invest in emerging companies, dominated the headlines. But with the big players based up north, Los Angeles start-ups were often bypassed in favor of Silicon Valley and Orange County.

After the dot-com bubble burst and the stock market tanked, local private equity firms re-emerged as key players. They have been fueled by billions of dollars in investments from major pension funds such as Calpers, municipal investments and university endowments--all seeking higher rates of return outside the capital markets.

Private Equity Fuels Growth

Many economists and industry players say private equity provides a crucial funding option for the small and mid-sized companies that now dominate the Los Angeles economy, allowing these companies to grow and the economy along with them.

"It broadens the pool of funds available to firms," said James Barth, senior fellow at the Milken Institute's Capital Studies Group.

Small companies have always had trouble shouldering the expense of underwriting a public offering, an expense that's gotten bigger with the Sarbanes-Oxley Act. Larger companies, too, can choose the private equity route if they don't want the additional scrutiny or the expense of going to the public markets.

Also, many small or family-owned businesses are reluctant to sell out to competitors when family heirs no longer want to run the company. They fear the prospect of consolidation that translates into job cuts down the line.

"Small and mid-sized companies often have limited options when it comes to raising funds. That's where private equity comes in. It provides liquidity that otherwise might not be there," said Chip Roelling, partner with Los Angeles-based Century Park Capital Partners. "That extra liquidity then can be redeployed to grow the company, which in turn helps grow the economy."

Another option for private equity is when the owners of a business want a small infusion of funding but don't want to sell out completely to another firm.

"We have thousands of middle-market companies in L.A. that face a point at which they need to grow or be swallowed up. Their margins are getting squeezed or it's getting harder to compete with bigger competitors," said Alex Cappello, founder of Cappello Capital Corp., a boutique investment bank. "They need to do something to take them to the next level. They need an infusion of fresh capital without too much leverage."

Cationary Notes

While few dispute the need for private equity, some are raising concerns that the local economy might become too reliant on it. Also, there are worries that the levels of debt now being raised for buyout deals may be too great to bear if interest rates rise sharply or the economy enters a downturn.

"The Internet bubble has taught us that if private capital chases deals that are unwise, there can be repercussions," said Stephen Levy, director of the Center for the Continuing Study of the California Economy in Palo Alto.

Critics of unrestrained private equity say the money has a tendency to go into sectors that are hot at the moment--and not necessarily into industries or sectors that are best for the long-term growth of a region.

"It can be an echo-chamber effect, where if one investment company goes in and does well in a certain sector, then everyone else must follow. That leaves other industries out in the cold," said Goetz Wolff, a labor economist and lecturer in urban planning at the University of California Los Angeles.

Wolff said that the region's biomedical industry, in particular, has suffered from a lack of private equity investment.

Also, private equity buyouts themselves can go sour, especially if the new owners don't know the industry or are too focused on short-term profits. Wolff said that a food-processing facility in Los Angeles that was bought out by a Chicago-based private equity firm felt just such a squeeze.

"The private equity firm brought in their bean counters and stifled any attempt to develop new products or invest in new equipment," he said. "First, the health benefits were cut back, then there were no more raises and finally there were layoffs. It was a negative multiplier effect."

Another red flag: the high levels of debt now involved in many private equity transactions. With interest rates low, private equity firms can take on more leverage and raise their offers. The trouble hits when interest rates rise or when the economy slows and the company doesn't generate enough profits to make the debt payments (something that happened after the LBO boom in the late 1980s). If several of these investments go belly up, that could have negative ripple effects throughout the local economy.

Critics also say that private equity transactions are largely unregulated and open to fraud and abuse.

"What's missing in these private transactions is transparency," said Madeline Janis-Aparicio, executive director of the Los Angeles Alliance for a New Economy, a living wage advocacy group. "That's how the corporate scandals we've seen over the last 10 years took root and it can happen here."

Outlook: Business as Usual

As long as the returns on private equity investments exceed the returns on Wall Street, billions of dollars will continue to pour into private equity firms.

"I see a lot of small public companies going private because they cannot afford to comply with the Sarbanes-Oxley Act," said Cappello. "That costs public companies at least $2 million to $3 million a year."

But the volume of transactions could plummet if credit tightens or the economy slows down. And there could be some fallout at companies that have recently gotten bought out and face pressure to make debt payments.