INVESTING: Private-equity deal-making driving up stock prices

The private equity folks are having a field day. In 2006, there was $160 billion worth of publicly traded companies taken private by private equity firms. In the last six months, several of these private equity firms have raised more than that from investors. Leveraging that money will create enough buying power to take almost every company in Japan private. But there is a competitor for those deals waiting in the wings, and these two Wall Street forces are going to collide soon.

A few years before the private equity group became the new “in” crowd, activist investors were scouting the public equity markets, looking for underperforming companies where they could badger management into making changes.

These investors, typically hedge funds or people like Carl Icahn, buy a large-enough stake in the targeted company to get on the board. Then, they try to get dividends increased or sales of lagging divisions. Generally, the hedge funds do not try to take over. Time Warner was a recent example of hedge funds agitating, and the stock went from $16 to $23 in five months.

Private equity investors have to be a little more discerning about the companies they choose to go after. A bad stock price is not enough. There has to be quality cash flows, usually in a company or industry that doesn’t grow much anymore, or where growth is stable and predictable (think Campbell’s Soup).

Heavy industry is a favorite because of the high asset levels. Private equity uses these cash flows and assets to leverage the company to the hilt. They pay themselves back right away with the borrowed money through special dividends. Then, after some sizable layoffs and a little reorganization, the private equity investors take the company public. It’s a virtuous circle of cash!

Being that there are only a fixed number of public companies that attract these players (you can rule out giants like Exxon and Microsoft), it’s only a matter of time before investors’ paths will cross.

They both want the opportunity to buy cheap, and having two deep-pocketed investors stalking the same prey will drive the stock up. And with a much higher stock price, management will be in a position to do some things on its own. Bidding wars soon could erupt all over the stock market.

It doesn’t take a Warren Buffett to realize what this could mean for the general stock market. First, it creates a natural floor of buyers if prices fall even a little (and in this case I mean 10 percent as a little). Second, as stocks react to these maneuvers and head higher, they probably have more upside than would be the case in a different set of circumstances. This is one of the reasons the Dow just broke out to an all-time high.

As I mentioned earlier, there are some sectors and industries that lend themselves better to drawing in activists and private equity firms.

I wouldn’t be surprised to see the likes of Caterpillar or Cummins Engine get in the mix soon. And this is not a long-term scenario. Both the hedge funds and private equity investors have to generate action quickly, or their money will be taken away.