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Private Equity Shakeout Looms

As investors turn away from risky debt, conditions for leveraged buyouts get tougher; firms with the sharpest elbows will be left standing.

By Grace Wong, staff writer

LONDON ( — As the benign market conditions that have fueled the buyout boom come under pressure, the swelling ranks of private equity firms are likely to be winnowed, leaving only the strongest and sharpest players.

Private equity is facing headwinds from a variety of fronts. Investors are starting to shy away from risky debt, raising worries that some of the biggest deals will have trouble securing financing. Congress is muscling ahead with tax rules on private equity, and interest rates are ticking higher around the world.

But while market conditions are starting to wobble, activity has not waned. “The bubble isn’t bursting, a little air is just being taken out of an inflated balloon,” said Paul Schaye, founder of Chestnut Hill Partners, a boutique investment bank in New York that works with private equity firms.

Bell Canada said Saturday it was being bought by a group including two private equity firms for $33 billion in cash, which would make it the largest leveraged buyout ever. On Monday nursing home operator Manor Care (Charts) agreed to be taken private for $6.3 billion and there was market talk about a possible private equity bid for Virgin Media (Charts, Fortune 500), whose biggest shareholder is Richard Branson.

As market conditions shift, only the strongest players will survive, according to David Buik of London brokerage BGC Partners. “Credit will not be available at the indiscriminate levels it has been at, and business will focus on the big companies – the Blackstones, CVCs and Bains – companies of that nature,” he said.

Well-known firms Providence Equity Partners and Madison Dearborn Partners are part of the group that has reached a pact with Bell Canada, while powerful Washington buyout shop Carlyle Group is behind the Manor Care deal, and is reportedly the bidder for Virgin Media. The British cable company confirmed Monday that it’s received a takeover offer but declined to name the bidder.

Low interest rates and aggressive lending by banks and other lenders have fueled the surge in take-private deals, in which buyout firms borrow heavily to purchase companies. Private equity deals accounted for about 34 percent of the $1 trillion in U.S. merger activity in the first half, according to deal tracker Dealogic.

Favorable market conditions and hefty returns have attracted several new players into private equity. The number of active buyout firms in the world has climbed to 676, up 55 percent from five years ago, according to London-based research house Private Equity Intelligence.

But too many buyout shops have stretched themselves too far and taken on too much debt, said Rick Rickertsen, managing partner of Washington-based private equity firm Pine Creek Partners.

Now investors in risky debt are pushing back. In a sign of the winds of change in the lending environment, U.S. Foodservice pulled a bond sale last week, and Dollar General (Charts, Fortune 500) tweaked its offering to drop a sale of so-called toggle bonds – which let borrowers pay interest by issuing more bonds instead of cash.

Service Master (Charts), which originally was slated for an all-toggle bond sale, postponed its offering last week and has restructured the deal, according to a market source. The company, which runs lawn care services firm TruGreen and the Terminix pest-control business, has reduced the amount of toggle bonds in the sale and is now due to price its offering on Monday.

Some expect the turbulence in the credit market to be short lived. “There’s growing risk aversion and the market is going through a reality check. But there don’t seem to be any major cracks in the system and the markets aren’t dramatically different than they were a few weeks ago,” said Sabur Moini, head of credit strategy at investment management firm Payden & Rygel.

He said a confluence of factors have created choppiness in the market: many big deals are trying to get done ahead of the July 4 holiday, creating a flood of supply; subprime problems at Bear Stearns (Charts, Fortune 500) brought risk back into focus for many investors; and mixed economic data further fueled uncertainty.

Going forward, market watchers expect a decline in “covenant-lite deals” – which give borrowers more leeway when they run into trouble – and fewer toggle deals. That means only the companies capable of putting up more equity are likely to pull off big deals.

No wonder many industry watchers said they expect at least three or four big private equity names to be public this time next year. KKR announced its plans to go public late Tuesday, and Carlyle Group and Apollo Management have long been considered prime candidates for the public markets.

Going public gives private equity firms access to huge amounts of capital. It also increases the ability of these firms to attract and keep the best talent, according to Timothy Spangler, a partner at law firm Kaye Scholer’s London office.

Blackstone (up $0.45 to $29.72, Charts) made a splashy debut with a $4 billion initial public offering. Shares have dipped about 3 percent from their $31 a share offering price, but the stock has only been trading a little more than a week.

“There are concerns about whether the buyout market is going to turn, but the success of the Blackstone IPO is validation of the fact that there is still a tremendous amount of money to be made in the buyout space,” Spangler said.