Tuesday, May 06, 2008

Private equity equals 'proxy for the credit markets'?

This Financial Times comment, “Private equity boom was nothing more than a clumsy trick,” dates back to March 31, 2008, by Michael Gordon, but having finished teaching my private equity class ten days ago, and sitting and reading papers from the 70 or so students in that class, I am pretty much convinced that this is the case. (For those of you who occasionally look at this blog for law of war and public international law, etc., my day job is actually corporate finance and international business law professor.) Excerpt:

So now we know. The boom in private equity, which was promoted as the superior business model, based on patient capital, superior management and an alignment of interests, was nothing more than a trick of financial engineering – and a clumsy one at that. The magic of leverage works both ways, as we are discovering.

Henry Kravis of Kohlberg Kravis Roberts is asking his investors to be patient after a bout of negative returns and writedowns, echoing the cries of Alan Bond and other entrepreneurs of earlier credit cycles. Hamilton James, Blackstone’s president, said at the Super Returns private equity conference on February 26: “We’re a proxy for the credit markets.” David Rubenstein, co-founder of Carlyle Group, recently asked whether “modest return” was a more apt name for private equity. He thinks it’s funny. It’s not.

As investors are increasingly bruised by the recognition that reality has once again triumphed over hope, the private equity barons are having to confess that the benefits of superior management, alignment of interest and, of course, the superior reward structure counted for very little.

Many of the private equity deals look no different from Yell and other highly leveraged public companies. As Warren Buffett notes, when the tide is going out, we find out who has been swimming without their shorts.

Sometimes a simple observation can prove an important point. In November 2006 Citibank published a research report that highlighted how private equity returns could be achieved by just leveraging basic stock market indices. It is a seminal note. “How do they do that?” asked the report, and then went on to provide the answer.

By leveraging the basic stock market indices by three to one, Citibank pointed out, returns could exceed even the best historical private equity returns. Never mind that as they were spellchecking the final version of the note, leverage on that season’s deals was reaching four to one and even five or six to one.

As Citibank pointed out, the private equity barons would always emphasise alpha over beta – their ability to outperform a market rather than merely ride the market wave – but it showed clearly that leveraged beta was where the returns were being generated.

My view is a pretty traditional one of private equity: that it is one end of the oscillation between public markets (characterized by weak control, leading to agency problems and inefficiencies, but relatively cheap cost of capital) and private equity (characterized by strong control, alignment of agency interests, but relatively high managerial costs to achieve gains). Firms move back and forth between those two points, or are threatened implicitly, or the market is threatened implicitly, with movement via buyouts and resale back into public markets. Superior management pays off at one point in the cycle; cheap capital at another. A pretty traditional view.

But after the Fed shovels so much capital out the door, then the business model is transformed from that into simple leverage. As Gordon, quoting Citibank, says, leveraged beta triumphs over patient alpha when the money is easy. So, as Hamilton James says, private equity is just a “proxy for the credit markets.”

For this, you get gigantic fees and a big premium? So much rent-extraction from the conveyor belt moving money out of the Fed? Remind me again what super-duper skill set it takes to take money from Ben Bernanke?

1 comment:

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