The big financial topic for 2007 (and hopefully, 2008) will be private equity. Or so says a number of top CEO's interviewed in a recent Australian Financial Review article.

The last year gave us great trophy deals: KKR jumping into Australia and buying the Cleanaway business, and painting a great big bullseye for other firms to aim at; the thwarted attempt at buying out one half of the grocery duopoly (Coles); the buyout of the Flying Kangaroo (Qantas); and so on.

It was also the year when people, having noticed the frequency that "private equity" and "leveraged buyout" was appearing in texts and flowing from everyone's lips, started to ask: what is it; is it good; and will it last. The year 2007 will have people sitting down with popcorn to watch and find the answer.

The "what" is easy. Imagine taking out a home loan. You put in a 10% deposit (more or less), and borrow the rest. You buy a house "with potential", you renovate, add bits and pieces, in the meantime paying the loan off using rent income or other income (most likely your salary). Then you pick a time to sell, and hopefully you sell at a nice profit.

For private equity, replace "house" with "public company", replace "income" with "operating cash flow", and there you have it.

The next two questions are much harder, and will depend on your perspective on the market. If you own a dog of a company, with bad management that you can't seem to get rid off, then a PE firm willing to pay a premium on the market price to take the company off your hands is a blessing. Same thing if you manage the company, are sick of the short-termism of the market, and have grand plans to make the company a success - if only someone would give you the capital and help you realise your dreams.

If, however, you are one of a (currently small but growing) number of people who believe the market is becoming/already is overvalued, then PE firms are to the market what petrol is to fire. Paying premiums for companies that are (in your belief) already overvalued is a sure sign that it's time to short some stocks. If you believe that most companies worth buying have already done all the cost-cutting and window-dressing that can be done, then PE firms will be buying companies that have no upside. If the market tanks during the typical 5-7 year investment horizon held by PE firms, then selling out at a profit (like selling a renovated home at the bottom of the market) will be almost impossible.

And of course, how long it lasts will depend on how long it takes until a major blow-up occurs and sends everyone running for cover.

This year will be an interesting one. Personally, I've been a believer in investments based on fundamentals. On one hand, I think PE firms do that: they buy firms with good foundations but mediocre structure or management, fix it up so the companies live up to their potential, and receive the rewards. They are the ultimate renovators.

But more and more, PE firms are paying higher prices, which to me does not seem like sound investing. It will reduce their ROI unless they do one of two things: borrow more as a proportion of the purchase price ("gearing up", which increases default risk), or somehow offload their investments to someone else at an even higher price. Whether that someone else is another PE firm or the public, whoever ends up with it will be playing a similar game of "pass the bomb" that was played in the late 90's/early 2000's during to dotcom bubble. But then again, I'm sure they know more than me, and that's why they're in the game and I'm not.

On the other hand, I've got to be feverishly optimistic about the prospects of PE in Australia, because my new job lives and dies by it. If the market tanks or PE firms go out of favour, the deal flow stops, and I sit there twiddling my thumbs (or worse, I lose my job and will have to go back to my old job).

At the end of the day, I believe PE is just like any other investment strategy: the asset has to be sound, the entry price low, and the exit price high. At the moment, I am beginning to wonder how much all three will hold up.