Gross: Private Equity's Next Takeover Target?

On the weekends, while private equity barons loll around their Hamptons estates, their lawyers, investment bankers, and junior partners hammer out deals. Every Monday brings the announcement of at least one transaction in which a private equity firm agrees to take a publicly held company off the market. This morning's example: Equipment rental company United Rentals agreed to be acquired by Cerberus for $4 billion.

Traders and arbitrageurs speculate feverishly about which company will be the next target of a voracious private equity firm. (Last week, the buzz was all about Macy's, for example.) The speculation isn't random: Private equity buyers like Cerberus and the Blackstone Group seek companies with certain distinguishing characteristics. These include (but are by no means limited to) the following: a stock that has been beaten down recently, allowing the buyer to get the deal done on the cheap; an underlying business with healthy margins that generates lots of cash, which will be needed to service the debt incurred in a buyout; a valuable brand and a long operating history that serve as ballast; little or no existing debt so that the new owners can borrow heavily to pay themselves dividends or to pay down the debt raised to acquire the company. Finally, the company should be one that finds being a public company more of a liability than an asset and thus would benefit from escaping the frequently harsh glare of public ownership.

Investment bankers, traders, and private equity types maintain sophisticated screening systems to scour for the right targets. My proprietary screening system is much less sophisticated, consisting as it does of reading Barron's, the Wall Street Journal, and the Financial Times while lazing in a hammock. But this weekend it spat out an interesting name. The next target of a private equity firm takeover should be a private equity firm: the Blackstone Group.

Blackstone, which just went public last month, seems to meet a large number of the criteria.

Declining stock price? Check. Blackstone went public at $31 and closed the first day at $35. But it has since fallen more than 25 percent and trades today at about $26. By offering a modest premium, Blackstone could take Blackstone private at a price lower than the IPO price.

A strong underlying business with healthy margins? Check. As the proxy shows, Blackstone manages a whopping $88.5 billion in assets. With the company's business model of taking a management fee of about 2 percent and 20 percent of profits, that's a recipe for spinning cash. According to its prospectus, Blackstone earned a total of $2.27 billion in 2006. Its operating margin on the core business of managing assets (before accounting for the firm's take of profits generated for investors) was an impressive 50.6 percent.

Valuable brand and long operating history? Check and check. Having been founded in 1985, Blackstone is among the graybeards in the burgeoning private equity industry. Among the big private equity players, only Kohlberg, Kravis, Roberts & Co. and the Carlyle Group enjoy similar tenures and name recognition. Blackstone has proven it can function profitably through recessions and expansions.

Lots of cash and little debt? Check. Blackstone's financials are extraordinarily impressive. It raised oodles of cash this spring by selling a 10 percent stake to a unit of the Chinese government, and from the initial public offering. And the company reported that as of March 31, 2007, it had an entirely manageable $610 million in bank debt.

Public status a burden? Check. Clearly, being public hasn't served Blackstone well. So long as Blackstone was a private entity, nobody particularly cared about how much co-founder and chairman Steve Schwartzman made, how much he pays (or doesn't pay) in taxes, and how much he spends. The public offering has changed all that. Blackstone's moves have focused attention on the fact that its partners pay taxes of only 15 percent on "carried interest"—the fee they get for managing other people's money. Two senators have introduced legislation aimed squarely at changing this advantageous tax treatment for publicly traded private equity partnerships—not privately held ones. In addition, Blackstone's public offering has inspired reporting by the New York Times' David Cay Johnson (subscription required) and Fortune's Allan Sloan that has revealed how Blackstone insiders have managed to reduce their already low tax bill further. As a private company, Steve Schwarzman and his sharp band of partners would be free to pursue tax-reduction schemes without having to submit the details to the prying eyes of reporters.

There's a final bonus to Blackstone taking Blackstone private. Buyout firms pay substantial fees to the investment bankers who steer them toward targets, and help structure, and negotiate deals. Blackstone, of course, has a well-regarded financial advisory unit. So, Blackstone's partners could essentially pay themselves for advising themselves to take Blackstone private.

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