Private equity – a clumsy trick with too much debt? | FT Alphaville

Private equity – a clumsy trick with too much debt?

It’s caused Michael Panzner at Financial Armageddon to revisit an old favourite, while Yves Smith at Naked Capitalism marvels at how otherwise sophisticated individuals want to believe in magic bullets.

We’re talking about the private equity boom being a trick – and a clumsy one at that.

So says Michael Gordon, writing an FT comment piece. He’s the global head of institutional investment at Fidelity International – so, even for the PE industry, this is not good press.

A taster:

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…

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.

Mr Gordon has dug out an old Citigroup note, which some PE investors probably wish they had read:

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.

Mr Gordon’s full frontal attack is available here.