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I’ve written previously about the private equity bubble/boom (depending on which side of the fence you are on) when discussing the IPO of the Blackstone Group (see coverage here and here). It has become a bigger discussion now that Blackstone has IPOed and is trading below the IPO price of $31 (even if it is up 2.3% today at time of writing). Well, look for that conversation to continue as Kohlberg Kravis Roberts, the granddaddy of Private Equity groups, has filed for an IPO.

KKR (as it is affectionately known) burst onto the scene in the 80s, most famously taking over RJR Nabisco in the largest leveraged buyout in history. It was so big that the record held firm until this private equity boom of the last couple of years. The takeover was documented in the book and HBO movie “Barbarians at the Gate” (I highly recommend at least watching the film). KKR is largely acknowledged as the company that perfected the leveraged buyout, where a purchaser forces the acquired to take on huge amounts of debt to finance the acquisition of itself.

That debt has been cheap during most of this decade as interest rates dropped to record lows after 9/11 and have been slow to rebound. However, the past few months have seen a marked rise in long term interest rates as the economy slows and the subprime market, which was also fueled by cheap and easy money, implodes.

Blackstone Group and another private equity firm, Fortress Group, went public to cash out for the founders of the companies who have enjoyed annualized returns over 20% for the past two decades. Those returns have caused everyone that can qualify to invest in private equity to throw as much money as the funds are willing to take in at the funds in hopes of replicating that return for the next two decades.

However, as anyone that has invested in previous hot mutual funds (such as Fidelity Magellan) knows, the more money these companies have to play with the lower returns will likely be. Essentially, this is because the low hanging fruit has been picked and the companies will have to accept lower returns in order to put the gigantic amounts of capital to productive use. While this would shield the funds from some of the blow from higher interest rates, the business plan for any private equity acquisition is to put in as little capital as possible and finance the rest with debt. Why? The business model is built on using debt, which is a cheaper source of capital as long as the interest rate is lower than the expected return on capital invested. As rates go up and the economy slows the cash flow from the acquired company will be able to cover less and less debt and the Private Equity groups will have to either put in more capital (at the higher cost) or cover the debt themselves (lowering returns).

Unlike the recent IPO of Blackstone, KKR will not be cashing out but rather putting the $1.25 billion from the IPO towards expanding the business.

I argued (and still do) that IPOs of Private Equity groups are a bad sign for the industry. These guys are pros at making money and knowing when to sell. Why don’t we believe they would do the same for themselves? Like I said with Blackstone, any time these guys are selling I don’t want to be on the other end. The more they sell, the more I’m convinced the end is nigh.