My Favorite Private Equity Players Just Flashed the Biggest Red Light Since 2008

Ask anyone who knows me, and they'll tell you I'm a voracious consumer of all news related to the private equity industry.

It's no secret that I even incorporate a lot of the same techniques as the most successful private equity investors into my own method of finding valuable stocks at unreasonably good prices.

But there's more to it than just checking in on the biggest players, like Apollo Global Management LLC (NYSE: APO) and KKR & Co. LP (NYSE: KKR).

Tracking the activities of the industry as a whole gives us some really valuable insights into what's going on in the markets and the economy.

So when private equity is engaging in a lot of buying activity in a struggling industry, things are probably pretty close to turning around. If there is a lot of selling, then the opposite is true.

If deal multiples are high, assets and companies are probably overvalued and near a tipping point. If deals are easy to finance, there's a good chance lenders are playing too fast and loose with credit, and we could be inching closer to the end of the boom. The same is true when we see private equity funds buried in cash as investors chase last year's returns.

And I have to say, what I see in private equity right now is deeply worrying...

Big Private Equity Players Are Tripping Over Their Own Growth

Right now, deal multiples are elevated, with firms paying as much as 11 times earnings before interest, taxes, depreciation, and amortization (EBITDA), which is near the dangerous levels last seen in 2007.

Not only are they paying higher prices, but private equity firms are also using a lot more debt to pay for the companies they buy.

Stock Market Crash

Case in point: Blackstone Group LP (NYSE: BX) just made a big splash announcing its purchase of Thomson Reuters's core financial data business for $17 billion. It's putting up just $3 billion in cash and borrowing the other $14 billion.

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That means debt will total more than 7.5 times the company's EBITDA, so the cumulative interest payments will not leave a lot of room for error. Again, that is back to the levels of borrowing right before everything blew up in the credit crisis.

What's interesting is where the money is coming from to finance all these deals. In the aftermath of the credit implosion, the banking regulators like the Federal Reserve and FDIC told the bankers "no mas" when it comes to the higher-yielding, higher-risk deals. Banks backed away from the high-risk buyout lending market, leaving a huge void.

Who rushed in to fill this need and make loans for private equity firms to finance buyouts? The private equity firms themselves, of course.

All of the leading private equity firms have developed debt and lending operations, and in many cases, they lend the money to themselves to do deals. Raising investor capital has been ridiculously easy because they could offer yields of 8% or more to investors desperately seeking alternatives to low-rate, traditional, fixed-income products. Best of all, these loans are usually floating rate, so if rates go up, investors are not left behind.

Initially, this was a massive opportunity for the private equity firms. The loans were higher-yielding, and they were lending to companies at fairly low valuations, as prices were depressed by the market and economic collapse.

The economy was slowly getting better, and they were able to cherry pick the best loans on the best terms. On Wall Street, success attracts imitators, however, and tons of capital have flooded into this type of direct lending in search of higher returns.

The increased competition for loans has driven down interest rates to levels that don't fully compensate for the risks being taken. Even worse, lenders are loosening the covenants or restrictions on uses of cash and minimum cash flow levels that must be generated by the borrower and are designed to provide a margin of safety for lenders.

There is so much money looking for deals that new entries to the private-lending game are taking lower returns for higher-risk loans and using leverage to produce higher returns. They are using borrowed money to make high-risk loans, which is never a great idea.

I have seen this movie several times in my more than 20 years in the business, and let me spoil the ending for you: They all die in the end...

Dangerous Lending Could Stop the Bull Market Dead in Its Tracks

So, the big question at the end of all of this: Why should we care if private equity firms are paying too much for target companies and using far too much borrowed money to do so? After all, won't that just hurt the PE firms and the folds - including themselves - dumb enough to make these loans?

That's not the case at all.

Private equity firms own more than $4 trillion in assets, including companies, real estate, and infrastructure projects. Whether they know it or not, the average American uses products or services produced by private equity-owned firms several times a day.

Stock Market Crash

A very wide range of food products, hotels, cable TV companies, car rental companies, data providers for the banks and credit card industry, office buildings, apartments, movie theaters, restaurants... the list goes on forever. Anything that impacts private equity companies will impact all of us.

If private equity firms manage to blow up their current funds by using too much borrowed money to overpay for target companies, it will cause severe disruption in the markets - and could even bring the stock market's nine-year-old party to an end.

What can we do about it? We can be aware that, in the past, when PE firms have been willing to use this much debt to pay this high a price, it indicated the party was winding down.

We can increase our sense of caution and avoid following them down the path of overpaying or increasing our risk levels to stretch for the last dollar of return.

Of course, just because this has always been the case in the past does not necessarily meant it will happen again. But much like I won't bet against the New England Patriots, I wouldn't bet against the private equity indicator flashing red, either.

As Sergeant Phil Esterhaus warned the men and women of Hill Street Station every morning, "let's be careful out there."

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About the Author

Tim Melvin is an unlikely investment expert by any measure. Raised in the "projects" of Baltimore by a single mother, he never attended college and started out as a door-to-door vacuum salesman. But he knew the real money was in the stock market, so he set sights on investing - and by sheer force of determination, he eventually became a financial advisor to millionaires. Today, after 30 years of managing money for some of the wealthiest people in the world, he draws on his experience to help investors find "unreasonably good" bargain stocks, multiply profits, and build their nest eggs. Tim tirelessly works to find overlooked "hidden gems" in the stock market, drawing on the research of legendary investors like Benjamin Graham, Walter Schloss, and Marty Whitman. He has written and lectured extensively on the markets, with work appearing on Benzinga, Real Money, Daily Speculations, and more. He has published several books in the "Little Book of" Investment Series and a "Junior Chamber Course" geared towards young adults that teaches Graham's principles and techniques to a new generation of investors. Today, he serves as the Special Situations Strategist at Money Morning and the editor of Peak Yield Investor.

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