• Rising stock values. If stock prices exceed the value of what private equity firms are willing to pay, then private equity firms will be less able to afford M&A. According to CFO, in 2006, private equity firms were paying about 13x Earnings Before Interest Taxes Depreciation and Amortization (EBITDA) -- above the typical private equity M&A range of 9x to 12x EBITDA. So private equity is reaching the outer limit of what it can afford. And if stocks keep rising, private equity will find itself at a bidding disadvantage to stock wielding strategic buyers.
• Increased financing risk. Although junk bond default rates have recently been relatively low -- 1.3% compared to the 4.5% average -- there is a disturbing trend towards a higher proportion of the lowest quality -- CCC-rated -- bonds. Specifically, nearly 16% of US bonds are rated CCC or below, up from 13.5% in 2005. Martin Fridson suggests that if the economy turned, the benign 1.3% junk bond default rate could rise to 17%. But this is not all. Corporate bond holders are starting to demand changes in covenants -- such as change of control puts and coupon step-ups for any ratings downgrade -- to protect themselves against losing their claim on a company's assets in the event of a takeover. These demands could make it harder to finance private equity M&A.
• Growing corporate skepticism towards private equity. For example, directors at Cablevision rejected a sweetened going-private offer and Health Management Associates' decided to do its own $2.4 billion leveraged recapitalization rather than be bought by others. This may be due to the lower prices that private equity paid vs. strategic buyers in 2006. According to AP, private-equity firms paid a mere 22.5% premium -- under the 25% that strategic buyers paid.
• Too much private equity capital chasing too few big deals. Private equity's high returns in the past several years have attracted new entrants. For example, according to the Wall Street Journal [subscription required], The Goldman Sachs Group (NYSE: GS) plans to raise a $19 billion fund. This will add to the $2 trillion in private equity buying power represented by the private equity industry's $750 billion war chest against which Knowledge@Wharton estimates $1.25 trillion can be borrowed. The pressure to invest these huge sums increases the chances of the kind of overreach that contributed to the last private equity collapse in 1989.
• Competitive advantages of strategic mergers. For well-crafted strategic acquisitions, the benefits to shareholders can be quite significant. According to a Peter S. Cohan & Associates survey of 30 big mergers concluded between 1998 and 2001, the ones in the financial services, energy and consumer products industries created market-beating returns for shareholders. Skilled strategic buyers' ability to use mergers to improve their competitive position and accelerate growth offer attractive returns to the acquirers' stockholders. These advantages are likely to remain important to many sellers.

To be sure, private equity firms continue to offer significant benefits to public company managers compared to strategic buyers:

• Big paydays. Private equity CEOs can often earn much more money than they would in public companies -- take former General Electric (NYSE: GE) exec David Calhoun who received $100 million to run a privately-held media company, VNU.
• Quicker deal approval. Private equity deals generally do not require the regulatory clearances -- such as antitrust review -- which strategic deals demand.
• Elimination of public company pressures. Going private relieves a company of its public company regulatory requirements and quarterly pressure to beat Wall Street earnings expectations.

Last week's record $39 billion deal for Equity Office Properties (NYSE: EOP) gave its CEO, Sam "Gravedancer" Zell, a $900 million payday. Meanwhile, Barron's estimates that Blackstone Group -- whose CEO Steve Schwarzman is planning a 1,500-star-studded 60th birthday party -- will get a 5% effective yield on EOP's properties while paying 7% interest on the $31 billion it took on to finance the deal.

If interest rates rise -- as two Fed governors hinted last week -- such deals could be jeopardized and private equity's M&A ascendancy could reverse.

Peter Cohan is President of Peter S. Cohan & Associates, a management consulting and venture capital firm. He also teaches Management at Babson College and edits The Cohan Letter. He owns GE shares and has no financial interest in Goldman Sachs or Equity Office.