Now You, Too, Can Be a Buyout King
Private-equity firms like KKR and Blackstone Group are offering shares to the public.
FORTUNE
Tuesday, June 1, 2004
By Julie Creswell

You have to hand it to Wall Street: It sure knows how to bait the hook. In recent weeks a number of gold-plated private-equity firms, including Kohlberg Kravis Roberts & Co. (KKR) and Blackstone Group, have rolled out plans to raise money in the public market. For small investors, the lure here is the chance to gain entry to these exclusive clubs where previously only institutional investors or the ultrawealthy could play. "Who doesn’t want to ride KKR’s coattails?" asks David Menlow, founder of IPO Financial Network. "There’s a lot of fame and fortune there."

This trend gained momentum in April when Apollo Management, a private-equity firm run by former Drexel Burnham banker Leon Black, raised $930 million for a closed-end fund called Apollo Investment Corp. It, in turn, plans to invest that money mostly in private companies with revenues between $50 million and $1 billion. Sensing an opening, nearly a dozen other private-equity shops, including Gores Technology Group, Thomas H. Lee, Gleacher Partners (managed by former Morgan Stanley banker Eric Gleacher), plus Blackstone and KKR, best known for its 1989 buyout of RJR Nabisco, also filed. If all these funds get off the ground�and that’s a big if�they could raise more than $6 billion.

These sexy new investment funds are really 60-year-old, dusted-off relics called Business Development Companies, or BDCs. Like real estate investment trusts (REITs), these BDCs have to spin out the majority of their income to shareholders. Wall Street brokers are hyping the higher yields (BDCs are expected to yield 8%, vs. 4.6% for a ten-year U.S. Treasury), to gin up investor interest.

For the private-equity firms looking to raise cheap cash fast, these BDCs are a huge boon: they usually have to woo pension funds and endowments for up to a year to gather the money they can now raise very quickly in the public market. The funds are planning to use the cash to take stakes in midsized companies that are too small to go public and are struggling to get loans due to bank consolidation. Particularly for KKR and Blackstone, these retail funds allow them to invest in companies that are too small for their institutional pools. Last, they get to collect some massive fees: Investors pay a 2% annual management fee, and the fund gets 20% of any income or capital gains.

But high fees aren’t the only drawback for little guys looking to invest. Investors will get scant information about private-company stakes, as they’re difficult to value. Also, private-equity investments may take years to earn a return, unlike stocks. Furthermore, the funds note in their prospectuses that closed-end funds, which trade like stocks, tend to trade at a discount to the fund’s net asset value. Seven weeks after going public, the Apollo fund is already down 11%, vs. a 3% decline in the S&P; 500.

Some observers already predict the days of this latest trend are numbered. "Everyone is trying to get into the party, but that means the market is going to get saturated," says Tom Taulli, who manages a small private-equity fund called Oceanus Value Fund. "KKR and Blackstone will get the deals done. The rest may be out of luck." Better them than investors.