KEY POINTS:
A private equity failure is inevitable and one bad deal could be enough to wipe significant value off New Zealand markets, says leading investment manager Arcus.
Arcus - which manages $5 billion in New Zealanders' savings - says the local sharemarket's record highs were substantially driven by the prospect of merger and acquisition activity. If such a merger was to fail, this would create uncertainty and sharemarket volatility.
"It is inevitable that at some stage, a private equity company will encounter difficulties," the company said in its quarterly investment strategy update yesterday.
Sharemarket advances were not supported by fundamentals, Arcus said. The economy was sluggish, the outlook for growth uninspiring and valuations starting to look expensive compared with overseas markets.
While "core" M&A activity was likely to remain strong, "the sustainability of the private equity boom is more questionable".
"Deals are becoming larger and more leveraged, and the prices being paid more expensive." Arcus said.
It was impossible to predict when a failure would happen, how large the company involved would be and how the market would respond.
"The most likely scenario is a brief period of market volatility and, eventually, a return in focus back to fundamentals."
Arcus chief investment officer Mark Brighouse said: "Where there might be a premium because of the possibility of private equity activity, that would come out of the prices of listed entities."
The size of such a premium was difficult to quantify.
"I don't think it's that great but it does partly explain why we've seen prices run ahead of earnings and why we've seen more of that in the smaller cap companies and more likely to be of a size that private equity buyers can digest."
He said an "interesting" facet of the private equity boom was that listed companies were increasingly being targeted. However, he questioned the claim that private equity firms could extract better returns from them by improving management.
Brighouse believed there were a number of problems with private equity ownership of businesses.
"A private equity buyer would tend to buy something that produces a good cash flow now and leverage it up as much as possible to try to create more return on equity, which doesn't suggest to me an encouraging long term investment driver.
"Any faltering in terms of top line growth could be a problem for those sorts of investors."
Risk and management
* It is "inevitable" that a private equity firm will strike difficulties sooner or later, says investment manager Arcus.
* That could affect the New Zealand sharemarket by wiping out some of the takeover premium in stock prices which have underpinned recent market gains.
* Arcus also challenges claims that private equity owned companies are more profitable than those which are listed.
