With such long horizons as one finds in the LBO world, it is quite easy to get very nervous about the economy. One is almost certain to meet at least a slowdown in any seven year period. Add to this the sudden bubble in private equity, and buyouts are no exception, and it is even easier to be even more nervous.
Someone once told me that the time to dump a sector is when you first hear someone who never traded a share of stock in their life tell you they were going long on it. Drop it like a hot rock. Today, everyone and their brother is pouring into private equity. It feels a little like venture capital in 1999.
Now add another wrinkle. Debt is plentiful and cheap. The Wall Street Journal's always interesting (sometimes scary) "Heard on the Street" is posting articles with titles like "Din of Roaring Corporate-Debt Market Drowns Out Growing Talk of a Bubble" (Wall Street Journal subscription required).
Says the Journal's Henny Sender:
But these blissful conditions are prompting rising concern among some veteran analysts about a possible bubble, fueled by a still-easy monetary policy, despite 14 consecutive short-term interest-rate increases by the Federal Reserve since June 2004. "The Fed hasn't done much," says William Dudley, an advisory economist for Goldman Sachs Group. "Overall financial conditions are much easier than in 2002."
The clearest understanding I had of the tech bubble boiled down to this: The thing you least want to be in a bubble is the greatest fool. The last guy (gal) to buy before there is no one more foolish left to pass the bag to. When you start creeping into people who have neither bought stock before, nor know anything about it, you are clearly running out of greater fools. Time to be worried.
In the tech bubble days the "greater fool" was the public markets. Armed with less information on what they were buying and more distant in terms of the number of intermediaries between them and the source of information to begin with, each intermediary, by the way, with an interest in passing it forward and taking a cut along the way so the stock gets more and more expensive with each jump, it is pretty easy to see how things get overpriced and overhyped.
The angels funded looking to dump to the seed gang. The seed gang funded looking to exit via the venture gang. The early stage venture gang funded looking to dump to the late stage gang. The late stage gang funded looking to pass it off to the investment banks via an IPO. The investment banks scraped the top off and tossed it to the rest of the market. The rest of the market looked to pawn it to... uh, the rest of the rest of the market.
None of the players early in the chain were all that worried. The deals they were cutting and the stability of the firms they were underwriting were quickly to become "someone else's problem." After they collected their fat checks. That sound you hear is the strained surface tension on the bubble.
Unfortunately, debt in buyouts has taken on similar tones. "Covenants" are eroding in an effort for groups to place more debt ahead of the competitors. The Journal article mentions Neiman Marcus and AMC as "covenant lite" deals done not long ago, with few if any serious restrictions by lenders. Why would lenders forgo their customary protections that reduce their risk over the lifetime of the loan? They have no intention of holding the loan for long, that's why. It's all about to become "someone else's problem."
An old tool, recently dusted off, called "Collateral Loan Obligations" packages a series of loans and boxes them up for sale in large chunks to other investors (who are quite a bit removed from the sources of information about the quality of these loans). Worse than that, CLOs are themselves bought by loans. Whole funds use 4:1 leverage to buy 4:1 leverage. That sound you hear is strained surface tension.
How do you know when you're running out of fools? Your investment of choice ends up on the cover of a major "McNews" publication like Time, Newsweek or such.
Thank god that's not happened yet. It's not like someone stole the name of my blog and put it on a McCover about private equity. -cough-
