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Tuesday, November 27, 2007

Hath Joined Together

let not man put asunderThis would not be the first time I used these pages to point out that the dynamics at play within the political machinery of private equity firms could be easily characterized by reference to powerful and diametrically opposed forces constantly at work against each other. I should not, therefore, surprise the astute Going Private reader when observing that within two years of a firm's formation, the senior partnership may find itself in recursive congress with a group it absolutely despises, namely the senior partners themselves. With five years to go in a fund with a seven year lifespan, the light at the end of the tunnel, obscured by smoke and dark steam, looks dim and distant indeed. When things go well, it may be easy to shrug off the personality conflicts and petty slights that define the day to day life of a senior partner. When, however, things go poorly, well, endurance can be stretched quite thin, and ruptures in the fabric of the firm's connective tissue begin to show. That thin, sporadic snapping you hear in the background is the sound of the firm's tendons tearing.

Private equity firms do not experience economic cycles in the same way as the rest of the economy. Inflationary or contracting, the firm, provided its investment mandate is properly aligned, can prosper. Dramatically rising asset prices serve as an ideal medium to acquire corporate divestitures and use leverage to spin off quick turn-around ventures. Coupled with (or even created by) depressed interest rates, these environments provide nearly ideal financial structuring based transactions. This, of course, is the environment we have, of late, enjoyed and abused.

Dramatically sinking or depressed asset prices provide equally interesting opportunities. A three year cycle of spiraling asset prices could well spur a value shopping spree. True, taking advantage of these environments requires a different (and rarer) skill set, namely, the ability to make operational improvements without resort to cheap debt, an eye for value investing, the ability to raise capital when private equity is not unduly fashionable anymore and a rare brand of investing patience. (This is the stuff that 6-10 year IRR calculations are made of).

It will be seen, then, that a well tuned firm stands to profit from either environment. The place that wrecks havoc with such firms is the gap between these cycles. The lull at the top of asset prices, and stomach lifting hump before the first roller-coaster drop. In other words, the last six months.

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