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By now everyone knows that Gap (NYSE:GPS) may be a private equity target. After David Faber reported yesterday on CNBC that Gap hired Goldman Sachs to help them consider strategic alternatives for the company, the stock spiked. Of course, the first thing that comes to mind is private equity, because private equity has been so popular during calendar year 2006.

gapLogoI am writing this article for a couple of reasons. The most obvious is to determine if Gap is actually a private equity takeover target, but we're not going to start there. First we'll take a look at some of the qualifications that private equity is looking for in legitimate takeover candidates. We'll look at some private equity names, and we're going to take a look at what drives private equity firms and the companies that allow themselves to be taken over; what's so good about private equity? I'll encapsulate this article with a technical analysis of GPS as well so that you know how to trade the stock as you wait for something to come from the recent Goldman Sachs news. By the way...

Gap's Fiscal year ends on January 28th

First a synopsis of private equity. KKR, Texas Pacific group, Carlyle and Blackstone are some of the biggest names in private equity today. Prior to 2006 investments in private equity were limited to the wealthiest of the wealthy. Pension plans, private investment firms and corporations were usually the ones involved with funding private equity. That changed in 2006. Brokerage Firms like Lehman Brothers, Morgan Stanley and other institutions have recently developed funds which allow their clients to invest in private equity companies. These funds are being offered to investors with limitations only as restrictive as those for private placements. This has opened the door for additional funding, and it is one of the components that has driven private equity in 2006. The catch is, when you start opening the door to more and more people, the regulators start opening their eyes too.

Debate looms over whether or not private equity will find hurdles in the coming year with government imposed restrictions and requirements. The cash flows generated by private equity though may keep the government at bay for the time being. Remember private equity depends on debt financing to make the buyouts which they propose. That means significant amounts of cash are changing hands when private equity deals close, and that is what keeps the economy moving. Obviously the Government likes the idea of a fluid economy.

But why is private equity so attractive? Before we tackle that question, let's make sure that we understand what private equity actually is: Private equity is simply the ownership of stock of a corporation that is not publicly traded. If you own shares, you would own shares in a private company, not a company whose stock was listed on an exchange.

Moving from the stock market to the private realm again can be very attractive to the executives running the company. The transparency required to list a stock on an exchange makes it difficult for any CEO to remain focused on the long-term. Wall Street wants quarterly results, if they don't see it Wall Street gets upset and share prices decline; then CEOs get fired. The situation with Bob Nardelli and Home Depot could be used as a case in point. Wall Street is just not patient enough to wait for long-term results, but private equity is. And that's with attractive about private equity. As a CEO of a private company, you are able to make long-term plans, and not worry about being fired due to quarterly fluctuations.

However as attractive as this may be to the company itself there are some problems for investors. Investors are not required to receive the same type of information that they get when they own shares of a stock on a publicly traded exchange, like the New York Stock Exchange. That makes the "private" company, far less transparent to the shareholder. If you're looking to make an investment that you can follow day in and day out, private equity clearly isn't the route that you want to take.

Private Equity firms target sound companies with long-term growth prospects, and the shareholders are willing to wait for that growth to transpire.

Important tangibles, which make a company attractive to private equity include the current valuation of the company, free cash flow, debt to equity ratios and a thorough analysis of the flaws in the current company.

With those bullets in our holster, let's take a look at Gap. Look at the table below:

gap1

The above flowchart shows you some key statistics for Gap, which private equity will consider when evaluating the company for a buyout. I have also listed the retail stores that Gap owns so that you understand what private equity will be buying if indeed a private equity deal takes place.

However, I have left out some key components. Specifically, I have not mentioned debt levels, operating margins, return on equity, or estimated growth rates. These four components are particularly important to private equity.

First of all, the debt to equity level a Gap is particularly low. The company only has about $500 million in debt, and it has $2.4 billion in cash. This is an attractive ratio for any takeover financed by the assumption of debt. Private equity companies look for companies which have low levels of debt. Gap is one of those companies

Private equity companies also look for takeover targets which have high operating margins. Again Gap is one of those companies. Operating margins at Gap are 8.39%. This is a high level for a retail company.

Next return on equity; the return Return on equity at Gap is 16.95%. If you are used to looking at technology companies, this doesn't seem like a very good number, but for a retail company the size of Gap, 16.95% return on equity ratio is very good.

Lastly, the forward-looking growth rates for the next five years: based on the consensus analyst estimates at Thomson financial the forward growth expectations at Gap are 12% per annum. That means that Wall Street expects Gap to increase earnings by 12% a year every year for the next five years.

If you have been following Gap so you know that the earnings expectations for the current year do not live up to those expectations. This could be one of the attractive points for private equity. I wouldn't say that Gap looks cheap based on a PE to growth ratio though, so don't misconstrue this statement. The peg ratio at Gap is 1.54. However, on a longer-term basis, if Gap is able to sustain those expected 12% annual earnings per share increases, the valuation of Gap over time is likely to increase considerably. Again, private equity isn't concerned with the immediate undulations in earnings. Private equity is interested in the longer-term performance of the company.

Private equity looks for good companies that Wall Street is disinterested in

Nothing could be more true than in the case of Gap. It is a sound company, the fundamentals are solid, but current earnings are a disappointment and the immediate quarterly growth rate of the company has Wall Street concerned. Over the long term though Gap is likely to perform well. This means that Gap is a attractive if you are willing to hold it for the long term, like private equity firms are willing to do. Clearly the $16 billion market cap poses some hurdles, but nothing that can't be overcome. Goldman Sachs is the number one investment bank on Wall Street, so no one could handle such a deal with more savvy. The Board of Directors at Gap including the Fisher family, who were the founding partners of the company, have made the right decision.

Usually, private equity deals take months if not years to come to fruition. However, recently these deals have happened much more quickly. We already know that some of the big names in private equity have been considering Gap. What we don't know, is the extent to which these companies have been negotiating with the executives at Gap. If these negotiations have been taking place over the course of the last few months, the coming of the end of the fiscal year for Gap on January 28 may mark the beginning of a new era for the company.

The Fiscal Year for Gap ends on January 28th

With that there are 19 calendar days remaining between now and January 28. If you are interested in trading Gap on the basis of a prospective private equity takeover I have created some specific trading plans based on a technical review of the stock to help you make those decisions.

Specifically, Gap has recently tested longer-term resistance. If GPS manages to break above longer-term resistance, we recommend that you buy GPS and hold it; we also recommend a tight stop loss just in case the stock reverses lower again afterwards. If longer-term resistance begins to break higher this time, the stock will likely accelerate from there. However, if longer-term resistance begins to break higher, and then the stock reverses back below longer-term resistance again, the technical indicators will become bearish and the stock will likely fall to $14.82 instead.

Source: Is Gap a Private Equity Takeover Target?