A Private Equity Bubble Is the Next Threat to Your Wealth

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A Private Equity Bubble Is the Next Threat to Your Wealth

Private equity funds are booming. According to The Economist,1 investors put $10 billion in private equity firms in 1991. In 2005, the funds brought in $250 billion, and the Financial Times forecasts that they will raise another $300 billion in 2006.

Why are they so hot? Investors are drawn to the funds because of their potential for high returns. Forbes2 reports that a few top funds earn 50 percent or more each year.

It is precisely because they are so attractive and so poorly understood that private equity funds are likely to develop into the next investment bubble over the next three to five years. They are following the same pattern seen in the early stages of other types of investment mania, from the 1980s Japanese real estate market to the 1990s technology stocks: The people who get in and out fairly early make most of the profits, and those who arrive late often pay the highest prices for the worst returns.

And theTrends editors aren’t alone in their concern. Mark Anson, the chief investment officer of the $175 billion California Public Employees Retirement System pension fund, has cautioned that private equity is the biggest investment bubble that he fears.

According to Goldman Sachs, there are now more than 2,700 private equity firms in the world. They have more money at their disposal than at any time in history. In 1980, Kohlberg Kravis & Roberts, or KKR, the private equity firm immortalized in the book Barbarians at the Gate,3 had the world’s largest fund at $135 million. As The Economist4 points out, several funds today have more than $1 billion each, led by J.P. Morgan at $6.5 billion.

A private equity fund can invest in new entrepreneurial firms or in aging companies that are past their prime. While venture capital investments in start-up and early-stage companies have been widely publicized, the other type of private equity investment is less understood. However, according to the Economist, less than 20 percent of private equity investment money goes to early-stage companies.

More than 80 percent is used to buy established public companies and take them private. According to a report by David Franecki of Lord Abbett,5 while the fund managers often claim that they restore ailing firms to health, what they do in most cases is focus on short-term gains.

This strategy is based on using leveraged buyouts, or LBOs, to acquire the company. The buyer issues debt to pay for the company, often in the form of high-yield bonds...

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