KEY POINTS:
You can forget the perils of global warming, terrorist attacks or the slumping United States housing market. The biggest threat to investors is private equity, which is on a world-wide, debt-fuelled spending spree.
New Zealand has been particularly vulnerable to private equity because of our low savings rate
and the eagerness of stockbrokers to promote highly questionable IPOs to clients.
Feltex - the low light of the 2006 corporate year - is a distressing example of the private equity phenomenon. TranzRail, now called Toll New Zealand, was another typical private equity transaction.
Several regulators and prominent businessmen are warning about the dangers of private equity.
Australian Reserve Bank Governor Glenn Stevens believes private equity investors are too optimistic and addicted to debt. He told a Melbourne audience that the excessive leverage could cause serious problems for the financial system in the years ahead.
National Australia Bank chief executive John Stewart believes "private equity is going to end up in tears - the only question is when".
These sentiments are being endorsed by regulators and business people around the world.
Private equity is an equity investment in an asset or company that is not listed or traded on a public stock exchange.
Private equity investors can be individuals, groups of individuals or pooled funds run by a private equity management company.
Graeme Hart's acquisition of Carter Holt Harvey, which valued the target company at $3.6 billion, has been the biggest private equity transaction in New Zealand this year.
Private equity has boomed in recent years because of the willingness of financial institutions to lend against the assets of non-listed entities. Thus private equity investors are similar to residential property buyers as they are able to borrow up to 80 per cent, or even 90 per cent, of asset values.
In an era of high and persistent equity returns, and a low cost of borrowing, private equity investors have achieved fantastic returns.
Private equity has also boomed for other reasons, including:
* Listed company boards have become increasingly compliant-oriented, rather than entrepreneurial, in response to the avalanche of post-Enron regulations. Private equity-owned companies are not subject to the same onerous regulatory regimes.
* Large superannuation funds are concerned by the increasing emphasis on short-term investment returns, and private equity allows them to take a longer term view for at least a part of their portfolios.
TranzRail and Feltex have been two high-profile examples of private equity in New Zealand.
A Fay, Richwhite consortium bought New Zealand Rail from the Government in 1993 for $328 million and changed the target company's name to TranzRail. The deal was a typical private equity transaction, with $223 million or 68 per cent of the purchase price funded by debt and the remaining $105 million by equity.
One of the first priorities of a private-equity investor is to sell surplus assets to repay the acquisition debt and/or make a capital repayment to shareholders.
TranzRail sold its 15 per cent stake in Clear Communication for $73 million and made a $100 million capital repayment in June 1995. This reduced the capital contribution of the original investors to just $16 million (additional equity had been issued to management between September 1993 and the share buy-back).
New shares were sold to the public through an IPO in 1996 at $6.19 each and most of the funds used to repay borrowings. Part of this debt had been raised to fund the capital repayment to the private equity consortium.
The rest is history as far as TranzRail is concerned. The company was engulfed in a sea of debt, Toll Holding acquired a controlling stake at a fraction of the IPO price, and a number of the former private equity investors have been subject to a long-running insider trading case initiated by the Securities Commission.
The Feltex saga is another example of the potential negative implications of private equity.
Credit Suisse First Boston Asian Merchant Partners (CSFB), a private equity fund, purchased Feltex from BTR Nylex in 1996 for $22 million. Five years later the carpet company bought the Australian operations of Shaw Industries and the transaction was almost totally debt funded.
Shortly after the Shaw transaction Feltex was up to its neck in debt with liabilities of $261 million and shareholder funds of $38 million, a gearing ratio of 87 per cent.
It is difficult to understand why financial institutions would lend up to 90 per cent of the value of the Feltex assets whereas they normally won't lend on even 50 per cent of the share value of listed companies.
CSFB and the carpet company's primary lenders, ANZ Bank, got lucky. In 2003 they convinced the New Zealand public to subscribe to $60 million worth of secured bonds and a year later an IPO was completed at $1.70 a share. The IPO enable CSFB to realise a profit of $182 million on an investment of only $22 million.
The IPO was a farce, as Feltex resembled the New Zealand Knights, which won only three of their 38 Hyundai A-League games, but were dressed up to look like Manchester United. Feltex didn't have the directors, management or coach to compete in any a-league.
The frightening feature of private equity is that there are thousands of highly geared private equity-owned companies, similar to Feltex, around the world. Many of these are under the stewardship of inexperienced and unproven management.
Private equity deals are getting bigger and more highly leveraged and when the world economy eventually slows - and the music stops - a large number of highly geared private equity investors, and their lenders, will be under extreme pressure.
This could have serious implications for the banking system, particularly if residential housing is weak at the same time.
Under this scenario, an avalanche of private equity-owned assets will be for sale. This is when sharemarket investors have to be particularly careful, as more Knights will be dressed to look like Manchester United.
Private equity has played a major role in recent developments at The Warehouse.
Stephen Tindall, the group's largest shareholder, originally proposed to make an offer for the discount retail in association with Pacific Equity Partners, the Australian private equity firm. This bid did not proceed after Foodstuffs and Woolworths each took a 10 per cent holding.
Foodstuffs is now rumoured to be looking at a takeover offer for The Warehouse in partnership with Pacific Equity Partners. This is a high-risk strategy for Foodstuffs because the share price of the target company has risen sharply and Pacific Equity Partners has a far shorter investment horizon than Foodstuffs.
Foodstuffs' chief executive, Tony Carter, said The Warehouse was a "good fit". If that is so why didn't he make a takeover offer earlier in the year when the target company's share price was consistently below $4?
Carter has to be careful he doesn't make an overpriced, highly leveraged offer for The Warehouse and put his well-run co-operative business at risk.