A combination of time constraints and (more severely) the psychology of personal reflection make it difficult for me to properly evaluate the true meaning my recent tendency to measure the passage of time by the regular arrival of The Economist. It seems only hours since I was reading the last issue and here is another one haunting me with ridiculously relevant insight and discussion (subscription required). The loyal Going Private reader will know this because I violate today my usual literary disdain for all subjects macro.
Most interesting, at least this hour, is the discussion on the importance of recession in economic cycles and the potential for some wholesome economicy goodness to issue forth from a slow down in the United States. I suppose it would be too clever by half to point out that it is conveniently easy for a British publication to call for a recession in the Colonies, though I think The Economist's piece falls short of that. I am sorely tempted to point good natured, if gently accusatory, fingers towards the red ink in The Economist's logo anyhow. Regardless, the piece brings up several important issues besides having the appealing property, always welcome in financial journalism, of using railroads as a metaphor. Says an uncredited Economist writer:
In 1871 America added about 6,000 miles of track to its railways, an endeavour that occupied a tenth of its industrial labour force. But by 1875 track-building had fallen by more than two-thirds, and employed less than 3% of America's workers.
According to Brad DeLong, an economic historian at the University of California, Berkeley, the violent ups and downs of the railway industry help to explain the popularity, before the Great Depression and John Maynard Keynes, of a fatalistic view of the business cycle. Recessions, however unpleasant, were cathartic, and therefore necessary. They released capital and labour from profitless activities (such as laying the year's 6,000th mile of track) as an essential prelude to redeploying them elsewhere. “Depressions are not simply evils, which we might attempt to suppress,” wrote Joseph Schumpeter. They represent “something which has to be done”.
Back in high school I had an economics teacher who ignored all hand wringing about the deficit or trade imbalance. "I expect it will just eventually be inflated or recessed away," he would quip. You would likely be forgiven today for mistaking him for Joseph Schumpeter.
In Schumpeter's day, this fatalism was shared by many at America's Federal Reserve. But today's Fed acts quickly to suppress recessions, which it recognises are mostly due to a lack of demand, not an excess of track. For the Fed, recessions are good for one thing, and one thing only: curbing inflation.
The Economist gets it exactly right, I think, in pointing out in a between-the-lines sort of way that a long brewing conflict between two schools of, if you will, recessionary thought, has come to a head. Internationalists, with increasing volume over the last few years, point to the dangers of foreign sovereigns and financial institutions dropping the dollar wholesale in anticipation of a future recession. Internationalists have typically been far more forward looking (at least when it came to monatary policy) than their domestic counterparts. Now, The Economist argues, forward looking thinking has become en vogue for the domestic bunch, as recession could be the cause of a current account deficit shrink rather than the reverse. Since, the Economist argues on behalf of domesticists (domesticates?), gross domestic purchasing is at something like 106% of GDP, there's room for a slowdown without any substantial job loss. As if the Phillips curve didn't have enough problems already.
This rosy view fails, suggests the Economist without quite suggesting it, to contemplate the structural changes that would be required of such an eventuality. A large shift towards tradable goods that would be required to make up for a strong slowdown in domestic spending (only 25% of goods produced in the U.S. currently are, if the Economist is to believed, tradable) would be needed to keep production stable. Housing, therefore, might have to take it on the chin. (Don't try to tell me you're surprised). What, pray tell, will become of the massive infrastructure in labor and capital that has heretofore been devoted to housing? Industry migration, or unemployment are, of course, the two options.
But let's put the macro thankfully aside for a moment to press weightier things, like Stanford grads. I leave you with this short-term takeaway: Monetary policy has gotten more long-term.
"Venture is getting a renewed boost and is set for a major comeback," one self-professed Stanford grad recently wrote me to complain about my failure to adhere to the equal-time standards of the private equity blogging industry. "All this buyout tallk [sic] is as much has-been bullshit. Why don't you send your resume out to some venture shops and start covering venture capital deals more?"
This chart might help:
Venture Buyout &
Number Capital Number Mezzanine
Year/Quarter of Funds ($M) of Funds ($M)
2002 171 3847.7 88 25731.1
2003 144 10680.2 92 29310.4
2004 201 18253.3 134 50953.1
2005 202 26530.8 175 94669.7
2006 YTD 105 17972.6 73 54383.7
2Q'05 56 7676.0 63 26446.0
3Q'05 62 5608.1 60 21677.4
4Q'05 70 8083.8 50 32491.0
1Q'06 64 6762.5 46 23575.0
2Q'06 50 11210.1 35 30808.7
Source: Thomson Financial & National Venture Capital Association
* These figures take into account the subtractive effect of downsized
funds
** This category includes LBO, Mezzanine, Turnaround and
Recapitalization-focused funds.
To put things in perspective, the three years ending 2001, probably the peak of the boom, raised $200 billion in venture money. The three years ending 2006 are poised to bore the bank with a paulty $70 billion in venture money. Texas Pacific Group alone raised almost a quarter of that just in Q1 2006. Fortunately, a permanant membership to the highly exclusive club of my junk mail filter is only a mouseclick away.
Says Joshua Radler, assistant project manager at Thomson Financial in what is likely the understatement of the year: "...this liquidity will have a significant impact on the dynamics of corporate America and the US economy in the coming year."
The capital hanging over the business is staggering. Even Henry Kravis is shocked... shocked I tell you to find there is fund raising going on in here. (Does anyone else think he and James Carville were separated at birth?) Consider the European impact as well:
A full quarter of all funds ever raised on the London Stock Exchange's AIM were raised in the first quarter of 2006.
Thomsons cited European private equity figures on fund raising as €72 billion in 2005, more than doubling the 2001 figures. Some €58 billion was destined for buyouts.
It has been fashionable lately to predict the death of private equity as we know it. Certainly, venture imploded even with substantial overhang and after record fundraising, but I just don't see the fundamentals for buyouts evaporating for reasons I've discussed here before. That being said, what would recession do for buyouts?
Personally, I think LBO firms have their timing almost perfect. A flurry of fund raising after several years of dynamite returns means they will be sitting on a pile of cash, much of it locked up, for years to come, waiting patiently for deployment in the right spots. Indeed, you have seen them casting a wider net for opportunities (ahem, Blackstone) and, at least in my view, the surest sign of the approach of a bubble burst is a wholesale resort to the public equity markets, there are after all fewer "greater fools," for exit (but at super premium retail prices). I cannot think of anything I would rather be than sitting on a pile of cash with multi-year lockups when the bubble bursts. My big worry is that there will be so much cash floating around prices won't fall fast enough even in the face of an economic downturn.
Those LBO firms that have failed to hold true to structural and incentive models that encourage (indeed mandate) long-term holdings will likely be challenged. The traditional LBO model, what I call the "purist" LBO model is to pick up trodden upon or out of fashion assets when their prices are low, impose cost cuts, apply consistent and disciplined management and remove the corporate form from destructive short-term accountability to shareholders (quarterly reports) so that it can be held for the long term and exited with an enhanced multiple.
Without doubt, the current environment is rife with opportunistic and highly creative examples driven by, among other things, SarOx, executive compensation, record low interest rates and public equity markets unable or unwilling to read debt ratios. As "smart money" what else would we have private equity fund managers do but provide returns?
Coming full circle, and in the face of what must be some kind of economic adjustment (The Economist, after all, asks "recession how" not "if recession"), what can we expect? A return to purism in LBOs? Outstanding. Now (or perhaps 6 months ago, depending on your temperament) would be the time to raise such a fund.
Personally, I'd put together a fund dedicated to the acquisition of firms that produce exportable goods. Hey, Going Private reader... you in?
(Art: "Martha Rebuking Mary for Her Vanity," Guido Cagnacci, post 1660- probably during his tenure at the court of Emperor Leopold I)
