When I first heard about the rumored $50 billion Dow Chemical Co. (NYSE: DOW) buyout, I thought it was speculative nonsense stirred up by a U.K. tabloid. It turns out my skepticism was justified.

Late yesterday, Dow flatly denied that it was having discussions about a leveraged buyout. Wall Street analysts thought a buyout was unlikely. The U.K.'s Sunday Express, which reported the story, first disclosed these rumors in February.

Whenever investors see reports about mergers, acquisitions or buyouts, they need to consider the source. News organizations such as The Wall Street Journal, New York Times, Bloomberg News or the Financial Times are very careful about printing stories about potential mergers and acquisitions. I don't remember a situation where a story where a story from these sources was flatly denied.

Remember that investment bankers use the business press all of the time to promote deals that they are working or would like to work on. This is like the child's game Whisper Down the Lane. Someone talks to someone else about a possible deal which becomes a potential deal than a likely deal. Eventually. people aren't sure how the rumor started in the first place.

But before you discount this story entirely, remember that the Sunday Express didn't come up with this idea by itself. Maybe this was a trial balloon floated by a banker or public relations person. I have no idea whether Dow management has ever spent one second even considering a buyout.

But as the hapless American Idol contestant Sanjaya Malakar shows week after week, anything is possible.

Signs of a coming slow-down in private equity are rolling in the way that news of leveraged buyouts have been for the past few years. On Friday, the Wall Street Journal reported that The Carlyle Group's CEO has written to the firm's employees to tell them to be more conservative, which may be viewed as a sign of a slow-down in the industry.

This weekend's Wall Street Journal reported that Blackstone Group is "in the advanced stages" of planning an IPO for 10% of its management company, which would set the total value of the firm in the $40 billion range. I see this as a sign that Blackstone's partners are ready to "cash out" and don't see an opportunity for much future growth. The Journal speculates that:

Blackstone IPO might well be followed by other well-heeled private partnerships -- whether hedge funds or buyout firms. Should that occur, it would signal a significant shift in the capital markets, which have become dominated by these firms that have prospered because they have access to cheap credit, aren't subject to the regulations governing public companies, and pay the executives at companies they acquire handsomely.

"They're monetizing the reputation that they've built," said Colin C. Blaydon, director of the Center for Private Equity and Entrepreneurship at Dartmouth University's Tuck Business School. "That often means you're at the top."

I think investors should continue to monitor the private equity situation closely. The bull market of the past few years has been driven partly by the growth in private equity, and a slow-down there could mean a slow-down for the entire market.

An article in today's Wall Street Journal (and also posted on Moneyweb) warned about the potential for disaster caused by the heavy debt loads imposed on companies being taken private through leveraged buyouts. Since 2002, the average debt to EBITDA ratio for companies acquired through leveraged buyouts has risen from 4 to over 5. Station Casinos, which recently received a buyout offer, could tip the scales with a debt to cash flow ratio of over 9. Is there danger ahead?

While it would be naive to think that some of the leverage buyouts of this past year won't end in bankruptcy, the news may not all be bad. In an era of executive overcompensation, heavy debt loads impose fiscal discipline on management. It is very difficult for a company to squander money on expensive office fixtures and foolish acquisitions when it is barely generating enough cash to meet its interest obligations.

The downside risk is that a large economic downturn or unforeseen disaster could toss these heavily-leverage companies into dire financial straits that cannot be avoided through strong discipline. But overall, big debt loads force executives to be more frugal with owner resources. When I look at stocks, I like to see the company taking on a certain amount of debt. Oftentimes, these are the best-run companies.

The last few quarters have seen a remarkable number of takeovers, buyouts and mergers. M&A activity is near an all time high, as the staggering amount of money sloshing around the global equity markets looks for something, anything, to buy. Interest rates are low, the money supply is growing (see this analysis of the now stealth M3 data over at the bigpicture), and private equity funds are competing with each other to find profitable investments. All of this adds up to a manic takeover market, and savvy investors are looking for a way to profit from it.

The Wall Street Journal speculates today [free link to AOL Money & Finance] on the latest potential takeover targets. The housing sector provides some interesting targets, since many housing stocks have been beaten down amid all the talk of the housing bubble. The article cites builders Lennar, Ryland Group and D.R. Horton as stocks to watch. Real estate investment trusts (REITs) may also be of interest.

Potential targets also include very large companies with good cash flow. These include Sprint Nextel, Hilton and Avis Budget Group. All of these stocks are up recently, perhaps due to investor speculation about possible takeovers.

One interesting note: The article points out that takeover activity is not as profitable as it once was. The takeover premium has fallen from 30% in 2001 to 17% in 2006. I would guess that this is largely a result of high levels of competition -- there's so much free-floating investment money out there that wildly profitable acquisitions tend to get snapped up right away, leaving less lucrative deals for later. The lower premium suggests that we may be in the late stages of takeover mania, and that takeover activity may fall after the next few quarters.