Private-equity raiders could be heading for a fall

published 7 August 2006

Yet another record bites the dust. The $33bn private-equity deal to buy US hospitals group HCA is the biggest-ever leveraged buyout (LBO), beating Kohlberg Kravis Roberts' $31bn purchase of RJR Nabisco, which has been the yardstick for 17 years. The big question now is whether HCA can produce a decent return for its new owners KKR, Bain and Merrill Lynch or whether such an enormous deal is just more evidence of recklessness and hubris in the private-equity industry.

It certainly shouldn't be hard for the HCA deal to outperform RJR; that buyout made less than 1% a year over a decade for its investors, says Rob Cox on Breakingviews.com. And the buyers look to be getting HCA very cheaply, at just under eight times last year's operating earnings. If they can grow earnings by around a quarter, then refloat the firm in around three years at a favourable rating, they could roughly double their money. But trends in the US healthcare industry don't make that a sure thing, says The Economist: costs are rising and revenues will be subject to a squeeze if the government HCA's major customer ever manages to reform the healthcare system.

So the deal is certainly not risk-free, but doesn't look crazy. The same cannot be said of some other developments in the industry. Nine of the ten biggest LBOs so far have been in the past 18 months, with both prices paid and debt used (measured as a multiple of earnings) rocketing. "When you put that kind of valuation on something, then you leverage it to a high degree, what you've done is to reduce the margin of error available to management," says bankruptcy investor Wilbur Ross in The Sunday Telegraph. He expects failed deals will rise sharply over the next couple of years. On top of the cost and debt, there's little straightforward value to be squeezed from these deals, says Richard Beales in the FT. The 1980's wave of LBOs were all about cost-cutting, but these ones are based on the firms' growth prospects so success will be dependent on earnings staying strong.