One doesn’t have to be a cry-baby like me to happily remember the radiant beauty of Julia Roberts as the hooker Vivian Ward in Pretty Woman (1990).

For many retail investors like me, it also marked the first time we got acquainted with the financial wizardry of ‘corporate raiders’, as epitomised by Richard Gere in the role of Edward Lewis, Roberts’ fairy-tale prince in this rags-to-riches romance.

Billionaire investor Lewis had it all, rubbing shoulders with celebrities and fellow billionaires. This was before the public started to get disenchanted with wealth-skimming financiers as portrayed a few years later by the TV drama Barbarians at the Gate.

The financial strategy at the core of such frivolous riches is called private equity, a form of investment initially reserved for wealthy pension funds and the dizzyingly rich. We retail investors were until recently excluded because of the large minimum amounts involved – mostly parcels of $5 million or more; the high risks; the long commitment periods – typically five years or more – and the strict confidentiality applied to deals, characterised by a dearth of financial data.

“It’s called private equity, be­cause, well, it’s private,” a wealth manager once quipped slyly.

This has changed radically. Many private equity funds, as well as some of the biggest names in the business, decided to operate as publicly listed companies, putting an end to secrecy, high entry thresholds and long investment horizons, as such shares are valued and can be traded on a daily basis and in much smaller denominations. For the fund operators it means that payday has been postponed ad infinitum, as the total fund investment has no sell-by date anymore. For us retail in­vestors it means we can join the party should we choose to.

Initially the term private equity (PE) was not coined to emphasise secretiveness but because of its capital allocation outside of public markets like stock exchanges. Increasingly it was understood as a financial operation aimed at taking publicly quoted companies off the markets altogether.

When a thorough financial analysis would prove that the share price of a company did not reflect its intrinsic value – book value, assets under management, achievable income streams, for instance – it could make sense to buy out all existing shareholders now and return to the public markets at a later stage.

The main pillars of PE profit­ability are thus rising stock markets and ‘leverage’: corporations are bought with a minimum of private capital investment, the lion’s share of money coming from bank loans secured by the target company which is taken over by existing, or new, management.

In other words, the money need­ed to buy a corporation is paid for by the corporation itself. If such ‘leveraged’ investment can be sold at a profit later, no matter how minimal, it would still be hugely profitable for its private investors.

Increasing company debt is not bad per se. It can make sense to operate a company with more debt than capital, as interest payments are tax deductible and loans gene­rally cheaper than the return expectations of shareholders in the form of dividends or buy-backs. Debt-financed investments will multiply returns. The downside is, of course, a higher bankruptcy risk when waters turn choppy.

For PE investors, who raise debt to finance their investment rather than to invest in a company’s future, their returns, leveraged by debt, will be boost­ed in the same way. These returns will be classified as capi­tal gain, not income, and therefore tax-wise treated much more lenient­ly. This too would boost PE results substantially.

The partnerships operating in this line of business are multi-billion behemoths. Enterprises like the Blackstone Group, TPG, KKR or Carlyle can bring money to the table that will cripple all possible defences put up by their targets.

Car rental company Hertz was bought for $15 billion, drugstore Alliance Boots for $24.8 billion, Hilton Hotels for $26 billion, and the food and tobacco giant RJR Nabisco, still the biggest deal in PE history, for $32 billion. At today’s money this is $56 billion, paid in an instance. For this feast, Kohlberg Kravis Roberts (KKR) were brandished as the ‘Barbarians’, as the shrewdness and Machiavellian aggression of the deal became notorious.

It is more than certain that we are approaching the beginning of the end

The returns on such deals became the stuff of legend. Money was earned in multiples of the initial amounts invested. So it is natural that as small-scale investors we should think hard whether we shouldn’t put our savings in PE funds too now that they are open to us. After all, people like Warren Buffet, who regularly invests alongside PE, can hardly be accused of being a dilettante.

PEs, when marketing their skills – and ever aware of their precarious public image – are of course loathe to attribute their financial successes to oversized bank debt and bull markets alone. They em­phasise the indulgent self-interest of the target management (‘agency costs’), their superior management skills, their expertise in developing new pro­ducts, to scale production and to conquer new markets, their finesse in ‘streamlining’ a company (selling off a lot of assets right away to repay debt), and their legendary prowess in ‘restructuring’ a company, which in essence means to fire as many employees as possible and to stop further capital investment, both a drag on a company now burdened with unusually high debt.

What is not publicised as much though are the deals that fail. And there are not a few of them. What usually breaks the pitcher at last are, of course, rising interest rates and stagnant or falling stock markets. When debt costs start to exceed the returns of the acquired assets, or the potential sales value of the assets start to fall below their purchase price, or lower even than the amounts borrowed for their acquisition, then things will start to look dire indeed.

No wonder that at this stage of the economic cycle, with valuations sky-rocketing and good opportunities to invest getting scarce, valued investors are increasingly offered ‘deal sweeteners’: a discount on the usually hefty management fees (two per cent) for a few years, or a suspension of the usually even heftier ‘success fees’ (20 per cent) when cash is finally returned, or both.

As emphasised in this column before, we are at the end of a bull market. And although nobody can tell with certainty when the party will be over it is more than certain that we are approaching the beginning of the end. From today onwards a retreat of the stock markets can be expected as political tensions intensify and interest rates continue to rise – in the US, in emerging markets, in Europe.

Neither forebodes well for PE.

In such a climate it is a reason for worry that PE funds, still awash with money, are outbidding each other to buy corporate assets at ever higher evaluations. Profits are easier made with good buys rather than over-priced sales. If a company is bought at crazy valuations today the chances are that losses will loom tomorrow.

What is fogging the picture and tends to mislead investors is the fact that assets, once taken private, are not priced to market anymore but subject to the generous accoun­ting concepts of PE alone. Funnily, PE valuations are much less volatile than shares in the stock markets, because they are frozen in time and open to wilful interpretation – again, not a very good starting point for a cautious investment and a good reason to stay away until valuations have come crashing down again.

Our potential love affair with Julia Roberts will have to be postponed, sadly.

Andreas Weitzer is an independent journalist based in Malta. He reports on the economy, poli­tics and finance. The purpose of his column is to broaden readers’ general financial know­ledge. It should not be interpreted as presenting investment advice or advice on the buying and selling of financial products.

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