Quest for returns boosts private equity: leveraged buyouts and other deals led by private equity firms are all the rage these days. Insipid stock market returns have brought institutional funds flocking to private equity, which is now able to buy very large, complex companies.

A decade ago, James Butter-field says, he cruised America's countryside searching out companies that would make good candidates for private equity deals.

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"I used to fly into different cities and drive around industrial parks with a tape recorder next to me," he recalls. "I'd speak the names of companies [into the tape recorder] and then look up the companies to see what they did. I'd cold-call them and ask them, 'Have you thought about joining up with a partner for growth?'"

That system worked well enough for him to recruit Southern Litho-plate, a family-owned company in Wake Forest, N.C., that makes lithographic plates used by community newspapers for offset printing. "It turned out that the owner was getting up in age," Butterfield says, recalling that the owner's wife prodded her husband to accept the deal, saying: "'Please, honey, let's take some money off the table and let our sons run the business.'"

Nowadays, Butterfield is still searching for good takeover candidates, but he seldom goes cruising. As regional director of deal sourcing and origination at the Riverside Co., an Atlanta-based private equity firm, he must abide by the current rules of engagement. And as private equity deals ("private equity" is the preferred term for investment firms that used to be generally known as "leveraged buyout" and "management buyout" shops) have become both better understood and more mainstream, more companies are being sold through an agent in a carefully calibrated auction system.

So while there are more good prospects than ever, say private equity firms, the buyouts are more expensive and, frequently, harder to accomplish. "You used to be able to go to Dubuque and make contact with the locals there, and you'd have a chance to see a deal," says David Lobel, a managing partner and cofounder of Sentinel Capital Partners in New York, a private equity firm that invests mainly in middle-market companies.

"But, now, the regional mergers-and-acquisitions boutiques have the country covered," he adds. "There are probably 30 firms that you can call and establish a relationship with over the Internet and the telephone. That's how you get the deal flow."

Among the best known regional boutiques that specialize in shopping companies to private equity firms are Harris Williams in Richmond; George K. Baum in Kansas City; Goldsmith Agio Helms in Minneapolis; Edgeview Partners in Charlotte; Lincoln Partners in Chicago and GulfStar Group in Houston. "There's a lot more sophistication in the market than there was only five years ago," says Colt Luedde, managing director of GulfStar. "I wish there wasn't as much competition [for deals], but from the valuation perspective of the owners, it's a very good thing."

Lobel says that prices have hit eight times cash flow, as measured by earnings before interest, taxes, depreciation and amortization, or EBITDA; that compares with roughly six times EBIDTA just five years ago. "It's almost shocking," he laments.

Says Dom DeChiara, partner and head of the private equity and investment funds practice at King & Spalding, a New York law firm: "In the auction process, bankers are doing a good job of extracting the last penny out of the private equity shops."

This rationalization of the marketplace is just one of several important trends occurring in the superheated private equity market. Amid a robust economy and against the backdrop of a stock market that no longer can promise the double-digit, bull-market returns of the 1980s and 1990s, institutional investors are pouring ever-larger sums of money into alternative investments. Along with hedge funds, private equity funds--which take an equity stake in promising companies, restructure them to make them more profitable, then cash out for a profit--have emerged as a prime beneficiary of money deposited by college endowments, pension funds, insurance companies and foundations.

The institutions serve as limited partners, or LPs. Even though the LPs are generally required to leave their money for five to seven years, "you see private equity funds raising new funds with more and more money, and there doesn't seem to be an end in sight," says King & Spalding's DeChiara.

Colin Blaydon, director of the center for private equity at Dartmouth's Tuck School of Business, agrees that "everybody is piling into it." He notes that employee retirement systems operated by corporations, unions and governments are especially prone to invest in public equity funds "at a time when the equities markets clearly aren't performing well. Underfunded pension funds are desperately looking for yields that can solve their problems," he adds. "Private equity is illiquid, but their historically high returns begin to look like the pension funds' salvation."

In confidential marketing documents, private equity firms often tout internal rates of return of 30-40 percent, with some top firms boasting past returns as high as 50 percent. The principals at private equity firms are well-rewarded for their efforts. Most top executives observe the "2 and 20" rule, charging a 2 percent annual fee of the LP's invested assets plus 20 percent of the profits at exit.

To cash out of an investment, private equity firms often sell the company to a "strategic buyer." Usually that's an acquiring corporation but, increasingly, another private equity firm or a company backed by another private equity shop. Exiting through an initial public offering (IPO) is less common, industry sources say.

Meanwhile, that promise of higher earnings for fund managers has resulted in the proliferation of private equity firms vying for deals. Investors deposited $106 billion into LBO funds in the U.S. last year, reports Private Equity Analyst, double the 2004 total.

With such enormous sums of money coursing into the marketplace, deals are becoming more outsized and more global. Many of the big firms are even teaming up--or "clubbing"--allowing them to engineer still larger transactions. In December 2005, for example, Clayton Dubilier & Rice Inc., a New York private equity firm probably best known for sprucing up Kinko's and selling it to Federal Express in December 2003, joined forces with Merrill Lynch and The Carlyle Group in the $15 billion buyout of Hertz from Ford Motor Co. And Toys R Us was taken private in July 2005 by a consortium that included Bain Capital Partners, Kohlberg Kravis Roberts (KKR) and Vornado Realty Trust in a $6.6 billion deal.

Not all deals work out, of course. The venerable Boston-based firm Thomas H. Lee Partners learned that last October with the bankruptcy of Refco Inc., in which it had a huge equity stake. The giant futures and commodity broker collapsed after it was revealed that Refco's CEO concealed $430 million in debt from the company.

And, U.S. firms venturing into Europe and Asia are being branded as interlopers. Most famously, a German politician has denounced foreign equity firms as "locusts." And, in the wake of the 200 takeover and successful IPO in 2003 of the renamed Shinsei Bank, led by Ripplewood Holdings, the Japanese are proposing a capital gains withholding tax designed to discourage foreign investors.

"It's known as the 'Shinsei Bank tax,'" says Dartmouth's Blaydon, who views the notion as "short-sighted." Blaydon contends that Japan would benefit from an infusion of private equity capital that would energize sclerotic companies.

Back in the U.S., with deal competition intense, buyout houses are striving to distinguish themselves from the competition as they woo limited partners, court prospective companies and build a track record in niche industries. For big name firms like Clayton Dubilier & Rice, for example, the chief task in hiving off Hertz from Ford was to convince the parent that it would, to paraphrase a Bobby Vee oldie, "take good care of my baby."

Though separated from Ford only since December, says CD & R partner Nate Sleeper, the buyout firm is already registering performance improvements. It rejiggered $8 billion of Hertz's capital structure, using asset-backed financing, and slashed its debt-service costs. In addition, the new management team instituted an incentive pay system for managers, reconfigured the company's off-airport operations and imposed tighter cost controls; Hertz is now denying car rentals to credit-challenged customers.

The Hertz deal is another sign that private equity is coming of age, Sleeper argues. "We think this is a landmark deal and a sign of the increased sophistication of the capital markets," he says. That such a huge, complex and sprawling organization could be taken private "legitimizes private equity," he says.

Neglected or under-performing divisions of giant conglomerates are highly coveted properties. Take Diamond Innovations, formerly known as GE Superabrasives when it was a unit of General Electric Co. Among its five product lines, it makes "super-abrasives" that cut and polish marble and granite, as well as drill bits used in petroleum exploration.

Tanya Fratto, CEO at DI, says the company is flourishing under the aegis of private equity firm Littlejohn & Co. One example: Within four weeks of being acquired, the company re-evaluated whether it would stay in the drill-bit business and, if so, what strategies to employ. Under GE, that decision-making would have taken several months, she suggests. "We're nimble, leaner and more focused," Fratto says.

Private equity firms are also targeting specialized markets and consolidating regional businesses to form national enterprises. Charterhouse Group, a New York private equity firm, purchased Vermont Baking Co., an organic bread-making concern with $15 million in sales in the Northeast, in February 2005. Using the Vermont firm as a platform, Charterhouse has added Adams Bakery of Milford, N.J., and Rudi's Organic Bakery of Boulder, Mo., which sells baked goods to Whole Foods, and instituted a new management team.

Now it is on the prowl for more organic bakers. "We're building a national distribution company," avers David Hoffman, a Charterhouse partner. "We've contacted many of the key players in the U.S.," he adds, "and even if they're not ready to sell, they're aware of us."

The intense competition is also wreaking pricing havoc for lenders. Jeff Geuther, a private equity lender at LaSalle Bank/ABN Amro in Houston, frets that "pricing on senior and junior debt has been compressed. We're seeing spreads come down to 150 basis points over LIBOR [the London Interbank Offered Rate] from 250 basis points just two years ago."

Praesidian Capital, a recently organized mezzanine fund, boasts a war chest of $363 million, of which $157 million is invested in four leveraged buyouts. The firm's partners have excellent contacts with both private equity firms and banks specializing in middle-market deals--which helps if it hits a rough patch. "Not every deal goes perfectly," says Neil Marks, managing partner, "so it's important for all sides to talk to each other and do the right thing."

Also contributing to a dynamic marketplace is what Geuther says is "the whole issue of the baby boom generation's getting up in age and taking advantage of a very strong market. I think a lot of people are thinking now is the time to evaluate whether to sell the business." Lobel of Sentinel Capital warns that negotiating the sale of a family-run enterprise is not for the faint of heart.

In taking over Canadian yarn manufacturer Spinrite Inc., located in Listowel, Ont., the family owner "wanted privacy--he didn't want everyone in town knowing about the sale," Lobel says. "And he didn't want to sell out to some big company. His family wanted to continue to be part of the fabric of the community and hold their heads high. And, he wanted a CEO who, while being from the outside, would be compatible with the town, its culture and its people.

"So the price was important," Lobel says, "but he insisted on selling to the firm he had the most compatibility with. That's how we won the deal."

Paul Sweeney ([e-mail]) is a freelance writer in Austin, Texas, and a frequent contributor to Financial Executive.

RELATED ARTICLE: takeaways

* Amid a robust economy and against the backdrop of a stock market that no longer can promise double-digit returns, institutional investors are pouring ever-larger sums into alternative investments like private equity.

* As private equity firms have become both better understood and more mainstream, more companies are being sold through an agent in a carefully calibrated auction system.

* Private equity firms often sell the company to a "strategic buyer." Usually that's an acquiring corporation but, increasingly, it's another private equity firm or a company backed by another private equity shop.