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Gulp!

We are living in the most freewheeling, unregulated financial boom in our history - and Boston's smack in the middle of it. Why should you care? Your company may be the next billion-dollar buyout by a private equity firm or your stocks could be in for a bumpy ride. Now do we have your attention?

"THESE THINGS USUALLY DON'T END WELL." Kevin Landry cracks a wry smile and sighs as he gazes out the floor-to-ceiling windows of his wood-paneled corner conference room on the 56th floor of the John Hancock Tower. Watching Boston unfold beneath us - from the Common, across the financial district, out to Logan Airport, the Harbor Islands, and beyond - it's hard to imagine that anything hasn't ended well for the genial head of TA Associates, one of Boston's largest and most profitable private equity investment firms. But he's serious. And he's nervous.

To understand why he's nervous - and why you should care - you have to know what exactly private equity firms do. (And don't pretend that you know just to avoid looking silly. It's OK, your buddy doesn't know either.) The easiest way to grasp private equity is to consider what it's not - public equity, or, as we more commonly call it, the stock market. In the stock market, everything, all the "equity," is owned by the public, meaning you and I can buy and sell pieces of publicly traded corporations like kids swapping Harry Potter cards. But in the private equity business, everything is held away from the public in "private" hands.

An example would be the group of tycoons who spent $25 billion to buy a publicly traded company like hospital giant HCA. In this buyout side of the private equity game, the idea is borrow as much money as you can to take control of a company, put in your own strategy and managers, and make the whole thing more profitable - and more valuable to resell. Of course, this sometimes means streamlining, layoffs, and cuts, but it's your money and now your company. Done right, a private equity buyout can pay off big time in no time, usually within five years or less. Think of it as Wall Street's version of Flip This House.

Today, these buyouts are the hottest ticket in high finance. Private equity firms throw off returns of 40 percent or more to their investors and make billions of dollars a year for their partners. All of which helps explain why it should be an enviable time to be Landry, or, for that matter, any other player in the lucrative corporate takeover business. Global mergers and acquisitions are flat-out exploding. In the first half of this year alone, deal making in the United States topped a record $1 trillion. Each day, another brand-name company, from Coca-Cola to Chrysler, is announcing plans to buy one of its rivals or sell itself to a group of financiers that will clean up the books and resell it all for a steep profit. Buyout speculation has helped drive stock prices to all-time highs. The fact is, if you work for a publicly traded corporation, chances are your management has a plan in place to deal with an eventual takeover bid.

But that's only half the story. In finance, as in the world of fashion, the latest trend is often mimicked to death. And takeovers are in danger of becoming those garish white-collared dress shirts from the days of Gordon Gekko. Buyouts have become so profitable that everyone wants to invest in them. Huge, multinational banks are offering loans at insanely cheap rates to the companies doing the buying, no strings attached, just to back one of these deals. The result is an outright feeding frenzy, where a company may be bought and sold for the same reason George Mallory wanted to scale Everest: Because it's there.

Which is exactly why Landry is nervous. And he's not the only one. "The inflation in value that's going on, the prices that people are willing to pay, and the amount the debt markets are willing to lend to justify these prices is just astounding," says Scott Sperling, co-president of Boston's Thomas H. Lee Partners, which recently teamed with cross-town rival Bain Capital to buy the radio network Clear Channel Communications Inc. for $19.4 billion.

If any of this sounds eerily familiar - skyrocketing values (see: real estate), overinflated stock prices (see: Internet), zero accountability (see: Enron) - it's because we've witnessed these waves of financial excess time and again. They're called bubbles, and when they pop they can be downright ugly, leaving average middle-class Americans trapped, working for the companies that go bust or investing in the funds that go belly up.

This is hardly idle chatter for Greater Boston, because so much of today's buyout business is based here. New England is the second largest center for private equity buyouts in the US (New York City is the first). It's little wonder, with Harvard, MIT, and so many other strong business programs nearby. In 2006, 11 percent of the Harvard Business School graduating class went into private equity. Bain Capital and TH Lee, two of the 10 largest private equity firms in the country, scour Harvard Yard for young talent like drooling college scouts at a high school football game. "Harvard always has been a huge player in the business," says Nabil El-Hage, a professor of management practice at Harvard Business School who used to work for TA Associates. "When I first started developing a course here on private equity and was looking for cases, I was amazed at the number of Harvard Business School graduates who are in leadership positions in the industry. It's really staggering."

MORE STAGGERING is the way private equity's making a small slice of Boston society so astoundingly rich. The biggest names pull in tens of millions, if not hundreds of millions, a year in pay, but in this business even the little guys get a healthy cut. A survey by industry consultant R. Michael Holt found that in 2006 the average employee at a firm specializing in buyouts took home $1.2 million in total reported compensation before taxes.

Out of nowhere, they've become our modern Vanderbilts, Carnegies, and Rockefellers (or, as some charge, the new robber barons, making their fortunes at the expense of the lowly workers). What's undeniable is that money begets power. Look at Mitt Romney, who used the millions he earned as Bain Capital's cofounder to bankroll his run for governor and is doing so again to help his bid for the presidency. Or Steve Pagliuca, who replaced Romney as one of Bain Capital's most public faces and led a private buyout of the storied Boston Celtics.

Today, Pagliuca has a vast compound with a tennis court and in-ground pool in a secluded area of Weston, near the home of TH Lee co-president Scott Schoen. Schoen's partner, Sperling, has a pastoral spread in North Wayland. Berkshire Partners founder and managing director Richard K. Lubin is on a cul-de-sac of mansions in West Newton, while J.W. Childs cofounder John Childs lives behind Soule Park Golf Course in Chestnut Hill. And Landry has a swanky apartment near the Public Garden lagoon.

Unlike old-school Boston Brahmins, who prefer to spread their fortunes around quietly, these new Boston barons tout their causes loud and proud. Lubin is treasurer of Dana-Farber Cancer Institute Inc. and treasurer and vice-chairman of Dana-Farber Inc., which manages the investments for the cancer institute. Sperling's wife, Laurene, a graduate of Harvard Business School, sits on the board of directors of the BELL Foundation in Cambridge and the Wayland Public Schools Foundation. Pagliuca is involved in a host of charities through the Celtics, while his wife, Judy, sits on the board of directors of Mass- Development.

So why all the worrying if things are this good? Just look at the numbers. In 2006, a record $3.5 trillion in corporate assets were bought and sold worldwide - and we're running well ahead of that rate through the first six months of this year. Plus, cash keeps flowing into the business: Private equity firms raised a record $261 billion for takeovers in 2006 and are on pace to shatter that mark this year. "It reminds me a lot of what happened in the late '90s," Sperling says. "Back then, the whole concept was suspension of disbelief. And that seems to be the case now. People don't believe that there's risk in the market anymore. I look at it, and I can't believe it's true. But it's happening. History is repeating itself."

Sensing disaster looming (and with memories of the dot-com crash still fresh), Congress has gotten into the act. In May, US Representative Barney Frank, the Newton Democrat who heads the House Financial Services Committee, chaired a hearing on private equity featuring a report by the Service Employees International Union, or SEIU, about the ways that a buyout can put a company and its workforce at risk when employees are laid off just to cut costs rather than to improve the business. "My major concern," Frank says, "is to minimize the extent to which these deals have an impact on workers."

Good luck, Barney. The people controlling all the money that's funding the buyouts are some of the wealthiest political donors out there; they would probably embrace more government regulation with as much enthusiasm as a dental patient would root canal.

If Congress is going to have any success reining in these new moguls, it might be through the IRS. For all the cash these partnerships generate, it's shocking how little they pay in taxes. Due to an arcane quirk in our tax laws, most of the money made in the buyout business is counted as long-term capital gains, rather than regular income. This lets private equity partners pay just 15 percent in federal income taxes on much of their earnings.

So, Congress wants to close that loophole. Economists estimate that updating the law just for private equity investors would raise between $4 billion and $6 billion in added tax revenues annually - more if you include hedge funds and venture capital firms, which also benefit from the quirk. The Senate already has introduced a bill aimed at publicly traded private equity firms like The Blackstone Group, the Manhattan partnership - and one of Boston's largest commercial real estate owners - that went public in June. And the House is proposing a more far-reaching bill that would raise taxes on all private-equity partnerships, as well as venture-capital firms and hedge funds. The Ways and Means Committee is planning to hold hearings on tax fairness soon. "I am genuinely concerned that some private equity managers may be inappropriately claiming capital gains for what should be ordinary income," says US Representative Richard Neal, a Springfield Democrat on the Ways and Means Committee. "It's simply not fair to the average person who cannot and would not engage in such games."

CONSIDERING THE RELATIVELY HUMBLE beginnings of the private equity industry, it's amazing that our new financial titans are coming from the world of corporate takeovers. Modern buyouts basically began on Wall Street in the 1960s at the trading firm Bear Stearns, where an unknown investment banker named Jerome Kohlberg Jr. was buying up companies with his two apprentices, cousins George R. Roberts and Henry Kravis. The partners launched their own private equity firm in 1976 - Kohlberg Kravis Roberts & Co., or KKR - but the overall returns weren't anything to get excited about. It wasn't until borrowed capital, called leverage, started flooding the market in the 1980s that buyouts became so profitable. In a leveraged buyout, a small partnership could take over a much larger company while limiting its own contributions to the deal. For KKR, leverage came in the form of junk bonds - essentially high-risk IOUs offered by struggling companies looking for quick cash - and junk bond maestro Michael Milken at the investment bank Drexel Burnham. It all came crashing down, however, when the junk bond market collapsed. Drexel Burnham went under, and Milken went to prison.

Just like that, our first great buyout boom was over and the humbled takeover world was looking for some positive publicity. It's no coincidence that today we talk, not of scary "LBOs," but of less menacing "private equity buyouts."

But jargon isn't the only thing separating today's buyouts from earlier ones. "The difference between the business today and in the 1980s is night and day," says Jonathan Nelson, founder and CEO of Providence Equity Partners Inc., who started at the Rhode Island buyout firm Narragansett Capital in 1982. "It was a lot easier then. First, the scale is much larger today. What we're doing is two or three orders of magnitude more than what we ever imagined back then."

Nelson also says that takeovers today are much more complex because the financial markets are larger and more sophisticated than they once were. To get a sense of what he's talking about, look at Bain Capital and TH Lee's takeover of Clear Channel Communications in May. The Boston private equity guys spent six months courting the San Antonio company (which owns several local radio stations, including Jam'n 94.5 FM and Kiss 108 FM) and went through two rounds of unsuccessful bidding, largely because Clear Channel's Boston-based institutional shareholders, Fidelity Investments and the investment firm Highfields Capital Management, fought the takeover. Ultimately, Bain Capital and TH Lee had to get creative. To seal the deal, the buyers increased their offer and, more importantly, agreed to allow shareholders to roll their holdings into a 30 percent stake in the new company.

Another reason that buyouts are trickier today is that the economy is more competitive than in the 1980s. Back then, there were plenty of opportunities for buyout partnerships to pick off a company, do some simple financial engineering, and resell for quick cash. Not anymore. Today, private equity firms are doing increasingly complicated deals where a particular expertise is needed to improve the companies they buy. "We look at a company and identify where there's room for improvement," says Mark Schwartz, CEO of Gordon Brothers Group, a Boston-based buyout firm that owns a variety of retail brands, including Andrew Marc, Laura Secord, and Spencer Gifts. "We kind of play the role of mentor. But it's not just financial. It's everything."

It means long hours and lots of travel for professionals in the buyout business, as they race around the world helping the companies they own or looking for new ones to buy. "The life is hell on families," Landry says. "All that travel, it really can be brutal." Adds Sperling: "If I have to leave the office early to go to one of my kids' soccer games and then stay up late at night on a conference call or catching up on work, that's a trade I'll always make."

OF COURSE, THOSE WARM AND CUDDLY SENTIMENTS ARE long gone come takeover time. Just look at the story of Pitts- field's KB Toys Inc. The company started in 1922 as a wholesale confectionery outfit called Kaufman Brothers and grew into a nationwide toy-store chain with thousands of employees. But competition from discounters like Wal-Mart and Target in the late 1990s was crippling, and, in December 2000, Bain Capital bought KB Toys for $305 million by putting $18 million in cash down and borrowing the rest. As conditions seemed to be improving, Bain Capital issued itself a $121 million dividend - a gain of nearly seven times its original investment - as part of a recapitalization that added more debt to KB's books.

Meanwhile, Wal-Mart started ruthlessly slashing prices again and KB Toys collapsed. In January 2004, it filed for Chapter 11 bankruptcy protection. The retail chain with more than 1,300 stores that Bain Capital bought just a few years earlier was sliced in half through the bankruptcy proceedings. Over the next two years, the company closed more than 600 stores, and 4,000 employees lost their jobs. Bain Capital executives blame Wal-Mart for ruining their plans. But the union that represents KB's employees is having none of that. "If they couldn't see that Wal-Mart was going to be wildly competitive, then they were smoking something," says Service Employees International Union executive John Adler, who is the director of private equity for the union's capital stewardship program.

Adler and the union say the KB Toys situation is a wakeup call for anyone who thinks the current merger mania can blithely continue with no consequences for American workers. And, as surprising as it seems, in many ways he's echoing fears harbored within the private equity world itself. The problem is, by the time private equity firms actually get around to doing something about it, it may be too late.

That's why Kevin Landry has decided to act. Peering out from his perch high above Boston, the TA Associates CEO says he's already preparing for the worst. His firm is paring down the number of companies it owns and spending capital very carefully. "There has never been a better time in the history of man to sell," he says.

His cautious tone, however, is hardly that of the booming private equity field these days. With money still flowing at record rates, larger and larger deals are getting done, and more people than ever are clamoring for a piece of the action. Maybe everything's fine and Landry's just overreacting. Maybe there is no bubble. But history would suggest otherwise, and that he's probably got a point: These things usually don't end well.

BIG DEALS

3,023
Number of buyouts by New England private equity firms from 1995 to 2007. (Second most in US, behind New York Tri-State Region.)

$47.6 billion
Sum invested in buyouts by New England private equity firms from 1995 to 2007. (Second most in US, behind New York Tri-State Region.)

$16 billion
Average size of New England private equity buyouts from 1995 to 2007.

3d
Rank of Massachusetts private equity buyout firms in total capital (behind New York and California).

$114 billion
Amount of capital controlled by Massachusetts private equity buyout firms as of December 31, 2006.

$19.4 billion
How much Bain Capital and TH Lee paid to buy out Clear Channel Communications - the largest private equity deal in New England.

Pop-up GRAPHIC: Big deals
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