The well filtered stuff at Abnormal Returns yesterday turns up a bit more scary news on the buyout front. This time by reference to a Forbes article titled "Private Inequity." (Subtitled: "The mad rush into private equity-is your retirement at risk?" Catchy, no?) It is a parade of horribles about all that is bad about "private equity" (though the article seems to fail to realize that buyouts are only one class of private equity investments).
Among other things, the article notes:
“There’s a group of new private equity guys chasing deals for the sake of putting money to work,” says Darrell Butler of Billow Butler & Co., an investment bank in Chicago. “They’re affectionately known as ‘dumb money.’ They’re going to have a hard time when the economy turns, profits go south and covenants get blown and banks come calling. And it will happen.”
No doubt. Well, except those smart enough to do "covenant lite" deals.
Over here we too have been feeling a lot like the tanks of money being poured around have been elevating prices beyond all reasonability. Still, seems people believe they can make money at those kinds of valuations. Everyone seems to be dumping money into the mega funds. Greater fool theory in large fund private equity? Uh oh.
The most interesting point the article makes, in my view, is with respect to pension funds. If you are an underfunded pension fund then alternative investments (like private equity) and those high returns are a tempting way to get yourself into three digit percentages of obligation coverage. The weaker the coverage the more allocation you will be tempted to put in private equity. A deadly race to the bottom? Maybe. Perhaps we'll see the weakest pension funds take the biggest hits if the private equity crunch is around the corner.
Then we have Warren Buffet berating the "hyper-helpers" for their high fees. (He means private equity and hedge funds). Of course, there are still investors lining up around the block to pay these "high fees." With returns to the top buyout houses upwards of 50% IRR why not? After fees they are still superior. Of course, the rest of the class doesn't command those kinds of returns. And here, as everywhere in the market, fees might bring total returns below even the S&P 500.
Certainly, there are some shifty practices in the buyout world. Don't even get me started on dividend recapitalization. But much of this recent language sounds to me like the national paranoia that hit in the 1980s in response to the buyout craze then. The Forbes article even dusted off the old "locusts" comment from Germany's Social Democrats. Ugh. I expected more than petty fear mongering from Forbes. Ok, nevermind, no I didn't.
Pretenders may jump on the private equity band wagon, and they may crash spectacularly, but solid professionals will always find ways to improve efficiency and add value though the incentives of debt. Buyouts are as American as apple pie.
The problems arise when funds get to big and unwieldy (-cough- Blackstone V -cough-) to manage well, and the law of large numbers starts eating into returns. Add to that the level of pain SarOx has mandated public companies now endure and then who could act surprised when they jump off the exchanges by the dozen?
No doubt there is a bubble. No doubt it will burst. Soon. But, as in the 1990s, buyouts will go on. Thank god I work in a smaller fund. I'm looking forward to seeing the riff-raff cleaned out.
-ep
