Private money

What happens inside the exclusive enclave of private equity is roiling the economy in a way that it never has before, says Fortune's Rik Kirkland.

By Rik Kirkland, Fortune

(Fortune Magazine) -- Picture your favorite teacher from junior high. Now picture her clutching her retirement savings and chasing the same deal as a room filled with posh investment bankers and flinty real estate moguls. It is an arresting image, yet during the battle for Sam Zell's Equity Office Properties, the Pennsylvania Public School Employees Retirement System was playing on not just one but three sides of the largest leveraged buyout of all time.

The $62 billion fund had done well in the past with high-risk investments, but this time the teachers had a lot of skin in the game. Their retirement fund had a $23 million stake in EOP's failed pursuer Vornado Realty Trust (Charts) and a $48 million stake in the target, EOP, and last February it also committed up to $200 million to the ultimate winner, Blackstone's Real Estate Partners Fund V. The result: The teachers ended up bidding against themselves.

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A battle between private-equity firms drove the price for Sam Zell's Equity Office Properties to $38.9 billion, the largest private equity deal of all time.
10 dealmakers that are poised to dominate the game. (more)

And as the battle between Blackstone and Vornado drove the pricetag higher, every dollar the Pennsylvania pension fund gained on its EOP investment was, in effect, being offset by the higher price that Blackstone now had to pay. Not to mention, as part of the price of victory, the teachers now have the privilege of handing Blackstone a 2% management fee and 20% of any future profits, plus a share of the hefty deal fees the firm will also charge for its labors.

The majority of these public servants are undoubtedly oblivious to the role that private equity is playing in their lives, and they are not alone. Do you start your day with a cup of Dunkin' Donuts coffee and lunch at Burger King? Shop at J. Crew, Toys "R" Us, Neiman Marcus? Rent cars from Hertz, watch movies at a Loews cinema, gamble at Harrah's, or sleep at a Fairmont hotel? All these as well as less visible products and services - the gas heat for many homes, cable systems, the satellites that enable your daughter's text-messaging, the hospital that replaced Aunt Millie's hip - are controlled (or were recently bought, then sold) by private-equity firms. And rumors continue to swirl that once-untouchable names such as Gap (Charts), Dell (Charts), Home Depot (Charts), even IBM (Charts) could one day be sucked into the private-equity vortex.

"The whole world of corporate ownership is undergoing dramatic changes, every bit as dramatic as when mutual funds first appeared," says investment fund manager Eddie Lampert.

Private equity is at the center of that change. Of the record $1.56 trillion spent on mergers and acquisitions in the U.S. last year, private-equity buyouts accounted for 25% of the action, up from 10% in 2005. Private equity's firepower has never been greater. Last year firms in the U.S. raised a record $156 billion in new capital. According to Blackstone, the global buyout industry currently has $400 billion available to be invested. With leverage, that $400 billion represents as much as $2 trillion in potential buying power. (To put this in perspective, U.S. mutual funds have more than $10 trillion in assets.)

Because private-equity funds, like hedge funds, are classified as "alternative investments," the two are often lumped together. And they do share common ground. Investing in both is limited to those with deep pockets, who can presumably handle the greater risk. Both feature lavish fee structures - variations on the "2 and 20" formula, in which general partners take a 2% fee for simply managing the assets they control and a 20% slice out of any incremental profits they deliver. Both soared in the wake of the 2000-01 market meltdown, which persuaded well-heeled investors that riding the market indexes (Dow 36,000! Nasdaq 10,000!) wasn't automatically going to make them richer.

But here's where they differ. While hedge funds mostly have individuals as investors, PE firms get the bulk of their money from institutions (roughly half from pension funds, another big chunk from banks, insurers, endowments, and foundations, and only 7% or so from individuals). Though so-called activist investors running hedge funds at times noisily pressure public companies into making changes to boost stock prices - think Nelson Peltz or Carl Icahn - most rarely end up owning companies; nor do they want to.

So what does this mean for those of us who don't wear pinstripes or dine where the elephants bump? Are we moving into an era when we have both a public and a private economy in the same way we have a public and a private educational system? Do Blackstone and its peers really take broken companies, mend their wings, and set them free in the public markets? And how big can private equity get, anyway?

Why now?

"Cheap debt is the rocket fuel for this, but it's not the only driver," says Rich Friedman, longtime head of merchant banking at Goldman Sachs (Charts), whose private-equity business has some $27 billion of assets (including a big chunk of the firm's and its employees' capital). "In terms of governance, management focus, and strategic decision-making, the private-equity model is usually superior to that of publicly held companies."

Every PE firm today sings from the same hymnal, which has several tunes. There's the ownership one. Unlike the "quick-hit artists" at hedge funds, says Blackstone vice chairman Tony James, "we are long-term investors who succeed only when our companies succeed."

That's typically followed by the it's-all-about-the-talent chorus. "Today anyone can raise equity and borrow money," says the Carlyle Group's co-founder David Rubenstein. "What's rare are two things: a deal everyone isn't clamoring to get into, and people who know how to operate the companies we buy. Given a choice between hiring an experienced investor for our firm and landing a guy who's run a leveraged buyout, I'd take the latter."

Amen, adds Michael Milken, whose nearly single-handed creation of the junk-bond market in the 1970s gave rise to the first great LBO wave of the 1980s. "The concepts and financial structures that we introduced back then - and that were rejected as too radical and poorly understood - are now in every introductory textbook," says Milken. "But success then and now mostly depends on finding great people. The difference is, where I only backed strong individuals who wanted to start or buy a business - Steve Wynn in gaming, Len Riggio in books, Craig McCaw in cellular, and Bill McGowan in telecom - the private-equity industry today has the scale to first buy up assets and then match them up with the right managers."

Another difference between Milken's era and today is that instead of merely bankrolling entrepreneurs, private-equity firms are co-opting CEOs. There are the elder statesmen - Lou Gerstner, Jack Welch, Larry Bossidy, Jim Kilts, John Browne, and many more - who have joined private-equity firms rather than retire to the golf-and-board-of-directors circuit.

More troubling for the future of publicly traded companies is that a generation of potential Fortune 500 CEO talent will continue to go private. Part of the allure is escaping the tyranny of quarterly numbers, Sarb-Ox and shareholder activism. Then there's the lucre. Last year former GE vice chairman David Calhoun, 49, jumped to run the newly privatized media company VNU for a reported $100 million pay package. Similarly, Mark Frissora left his CEO job at publicly traded auto-parts maker Tenneco to run Hertz, which is jointly owned by Carlyle, Clayton Dubilier & Rice, and Merrill Lynch.

The brain drain doesn't end there: While reporting this story, I got an unsolicited e-mail from an outfit called Private Equity Access promising that "as a leading executive" I was a "prime candidate" to run a PE-owned company. For a special introductory annual fee of just $149, it would match me with the right partner firm and make my dream of "better pay and greater freedom" come true. (Ah, yes.)

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Market indexes are shown in real time, except for the DJIA, which is delayed by two minutes. All times are ET. Disclaimer LIBOR Warning: Neither BBA Enterprises Limited, nor the BBA LIBOR Contributor Banks, nor Reuters, can be held liable for any irregularity or inaccuracy of BBA LIBOR. Disclaimer. Morningstar: © 2014 Morningstar, Inc. All Rights Reserved. Disclaimer The Dow Jones IndexesSM are proprietary to and distributed by Dow Jones & Company, Inc. and have been licensed for use. All content of the Dow Jones IndexesSM © 2014 is proprietary to Dow Jones & Company, Inc. Chicago Mercantile Association. The market data is the property of Chicago Mercantile Exchange Inc. and its licensors. All rights reserved. FactSet Research Systems Inc. 2014. All rights reserved. Most stock quote data provided by BATS.