2007 the Year of Private Equity

After much gnashing of neurons, we think we've nailed down the big theme of 2007, Private Equity. It's the NOCs vs. The Pirates. The Great Battle for Energy Equities is heating up. Specifically, we're talking about the convergence of the pirate equity boom with the bull market in energy. The two should combine in 2007 in what his shaping up to be an intriguing battle at many levels. Private equity firms and their ultra-rich clients will find themselves directly competing with National Oil Companies (NOCs) across the globe in a fiercely competitive bidding war for the energy assets of publicly-listed stocks.

Private equity analysts must do the same thing you and I try to do each day as investors: buy a dollar's worth of earnings for less than a dollar. The private equity world has added a twist. Private equity buys a dollar's worth of assets for $1.20, but puts only about .40 cents down of real money. The rest is financed.

That kind of leverage makes any sort of deal possible. But in order to finance the borrowing it takes to do a deal, you don't want to enter into just any sort of deal. The target acquisition must either have lots of cash per share (to finance the debt), sell at a deep discount to sales or book value (making the miraculous turn around and asset flip easier for the management plan), or be in a sector in which demand is growing buy supply is scarce (in which case the pirates are counting on booming earnings in the near future.)

A quick glimpse at recent private equity deals shows a remarkable diversity in the kinds of firms being taken private. Equity Office Properties (NYSE: EOP)-a real estate investment trust-was bought out and taken private early this year by the Blackstone Group for $19 billion. Radio company Clear Channel (NYSE: CCU) went for $18.7 billion. Just this week the world's largest casino outfit, Harrah's Entertainment (NYSE: HET), was offered $19 billion to go private and join the dark side.

But it was to recent deals that really got our attention. First is the proposed merger between two Norwegian oil and gas firms, Norsk Hydro (OSL: NHY) and Statoil (OSL: STL). Second is the private equity $15 billion dollar offer for gas pipeline company Kinder Morgan (NYSE: KMI). And here (finally) is where the energy bull market meets the private equity market.

There are two factors which make more private equity bids for energy assets more likely, though. The first is that the supply of well-managed energy companies with good balance sheet value is limited. When you're borrowing money to buy good assets, money is no object. Private equity is keen to buy scarce and quality assets, wherever it can find them. The energy sector presents compelling value.

The second factor that puts energy assets on private equities radar is that underlying scarcity that's driven energy stocks higher since 2004. Oil and gas are getting harder to find. Publicly traded energy conglomerates and nationally run firms are finding it harder to replace annual production with new reserves, especially given demand keeps rising and discovery of new reserves keeps falling. Private equity sees the fundamental picture for energy assets being very bullish and would like to get in now, while credit remains cheap, energy prices remain high but stagnant, and before other bidders start arriving.

And there WILL be other bidders. That is the third and final factor leading to higher prices for energy assets in 2007. Private equity buyers will find themselves engaged in bidding wars with state-run oil companies flush with cash but desperate for new sources of production, as well as countries like China and India, flush with cash from trade but also in desperate need of secure energy supplies.

It will be a great energy equity rush. And as an investor, the obvious question is which companies will be most coveted? Ultimately, since private equity borrows money, many kinds of assets across sectors will go up somewhat indiscriminately in 2007 as the super rich battle it out for control of the world's capital assets. But there are a few assets which are most plum, and those would be oil service companies and oil exploration and production companies.

On the back of the Kinder deal is speculation that service companies like Diamond Offshore (NYSE: DO), Global Santa Fe (NYSE: GSF), and Noble (NYSE: NBL) could be next. There are worse ideas than going long those stocks for 2007. Or, if you're a speculator, buying in-the-money call options on the Oil Service Holders (AMEX: OIH) is a way to be long private equities most sought after assets for a few hundred dollars per contract.

Either way, the convergence of the energy bull market, the emergence of private equity as a kind of counter-attack of the world's super wealthy elite, and the growing race for control for scarce energy assets all adding up to an epic bull market in energy stocks.

Of course it could all come to tears rather quickly. In a recent article, Australian James Cumes writes the following, "We need to keep in mind the essential nature of private-equity and other financing identified with what I have called the "Goldman Sachs phenomenon". In 'America's Suicidal Statecraft', I have suggested that the crucial consideration is the quality of the investment represented by the phenomenon. Is it new real fixed-capital investment or is it simply transfer of ownership?"

"If it were the latter, it was another example of that redefinition of investment so common in the last quarter century, especially in the larger Anglo-Saxon economies, whereby transfer of ownership supplanted fixed- capital investment as the most common form of what purported to be "investment." Investment became a means of making a fast buck, not by entrepreneurial effort, construction of factories and installation of productive equipment, but by gambling to add market value through mergers and acquisitions including privatisations that would lead to higher shareholder value in the marketplace. Those higher values might be short- term and would have to be gathered quickly before more fundamental disabilities became apparent and prompted longer-term declines in values. Despite the higher, short-term market values, they would not necessarily add anything to productivity or to the volume or value of final output"

"Inevitably," he continues, "there are social impacts from this deal- maker, day-trader, casino-like type of ownership investment, especially to the extent that it spreads over a more and more major part of the economy…Inequality is dramatically intensified by generous bonuses for senior executives and others in financial firms in the United States and such other financial centres as London. The 2005 bonuses in Wall Street set new records of $21.5 billion in aggregate and $125,000 on average for individuals. Thousands received bonuses of $1 million and more in New York and three thousand pocketed one million or more pounds each in London. The chief executive of Goldman Sachs earned a compensation package of $38 million for 2005, the head of Lehman Brothers $15 million and just six months' work at Morgan Stanley brought its new head $11.5 million. The bonuses would, it was said, be spent largely on 'multimillion-dollar estates, rare art, luxury cars and fractional shares in private jets'"

"Of course, there is justice in rewarding effort and enterprise. That is historically one of the ways in which a capitalist system has justified and maintained itself; but there are other considerations too. Indeed, if our present essentially democratic capitalism is to survive - and survive securely - it must pay attention to social outcomes. Poverty in the midst of plenty is not a comfortable social situation. Some inequality there will always be but gross and growing inequalities must, over time, be a threat to social, political and even strategic stability, as well as economic and financial stability."

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