Private-Equity Buyouts Stir Concerns

Private equity firms have bought Chrysler, Bausch & Lomb and the student-loan company Sallie Mae. But the structure of the deals has some — including Fed chief Ben Bernanke — concerned they could hurt the economy.

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Private equity firms have been putting on the big show, but some people are concerned. These are the companies that make money by buying and then selling companies after making some changes. And they've had a very busy year. This month alone, they bought Chrysler and the student loan company, Sallie Mae. But Federal Reserve chairman Ben Bernanke recently rattled the markets when he expressed concern that some of these deals could pose risks to the economy.

Here's NPR's Jim Zarroli.

JIM ZARROLI: In 1988, Colbert, Cravis, Roberts purchased RJR Nabisco for $25 billion. It was the biggest private equity deal in history, and it held that distinction for years. Then last February, the firm topped itself, buying the utility company TXU for $44 billion. Both deals were highly leveraged, meaning Colbert, Cravis, Roberts had to borrow most of the money to pay for them.

But in a lot of other ways, the deals are different. Colin Blaydon of the Tuck School of Management at Dartmouth says private equity debt is a lot more complicated than it used to be.

Professor COLIN BLAYDON (Tuck School of Management, Dartmouth): It's sort of like your, the question about your teenager - you know, do you know where your teenager is tonight? If you ask these folks, you know, do you know who's holding your debt and where it is right now? They can't really answer that question.

ZARROLI: In the old days, Blaydon explains, private equity firms used to borrow the money to buy companies from banks. And banks might hold on to the debt for years. Blaydon says these days, firms still go to banks to borrow, but the banks now package the debt in complex products like credit swaps and resell it to other investors. So instead of owing money to the banks, Colbert, Cravis, Roberts is really borrowing indirectly from a huge pool of many different lenders.

Mr. BLAYDON: So no one is quite sure with any of these packages exactly where all the pieces sit, who holds them, who really is carrying the risk.

ZARROLI: Private equity companies say the way these deals are structured is a good thing. They say having a diverse pool of lenders spreads out the risk, and so the banks are less vulnerable if there's a recession. The banks feel like it's safer to lend, and they offer better terms.

Doug Lowenstein is president of the Private Equity Council.

Mr. DOUG LOWENSTEIN (President, Private Equity Council): The lone terms are structured so that the company has a lot more flexibility to work through the downside to avoid any disruption in the business so that the banks are not going to be pushing companies into bankruptcy as quickly as they might have 10 or 20 years ago.

ZARROLI: So what's making people like Ben Bernanke nervous? For one thing, some individual deals now involve a lot of leverage. Just as a homeowner can get a mortgage with just five or 10 percent down, private equity firms now have to put up less of their own money when they buy companies. Colbert, Cravis, Roberts is expected to put down just 20 percent to buy TXU. Second, a lot of the debt from these deals is being bought by hedge funds. And hedge funds are famously unregulated and secretive.

John Lonski is chief economist at Moody's Investor Service.

Mr. JOHN LONSKI (Chief Economist, Moody's Investor Service): Mr. Bernanke's concern is that hedge funds are - for the most par - opaque. We really don't know as much as we would like to know about the state of their underlying financial condition.

ZARROLI: The risk is that hedge funds get in over their heads and deals begin to go bad. And because a lot of institutional investors like pension funds put money in hedge funds, the damage would cascade throughout the economy. Lonski says there's no reason right now to think hedge funds are at any risk, but he says nobody foresaw the collapse of the hedge fund Long-Term Capital Management in 1998, either.

Mr. LONSKI: And thus, I can't state with confidence that we will avoid having any problems with hedge funds that could bring about disruptions to the overall financial system.

ZARROLI: All this is a worst-case scenario, but Fed officials say it's important to understand the risks now, before it's too late to do anything about them.

Jim Zarroli, NPR News, New York.

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