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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.

This entry was posted by Paul Murphy on Tuesday, April 1st, 2008 at 15:01 and is filed under Private equity. Tagged with . You can follow any responses to this entry through the RSS 2.0 feed. Responses are currently closed, but you can trackback from your own site.

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Comments

  1. Apr 02   0:01 Posted by Anonymous [report]

    http://financialpetition.org/petition-impeach.shtml

  2. Apr 01   16:24 Posted by VP [report]

    Am a huge fan of NN Taleb; Fooled By Randomness a v. good book.

    “The most successful traders at any given time are never the best traders”.

  3. Apr 01   15:45 Posted by Anon [report]

    It’s like any boom. What was once an appropriate route for some quoted businesses, eg neglected but solid smallcaps, turned into a mania.

    Academics have shown that net of fees, most hedge funds offer little more than beta and sometimes worse, studies show private equity is similar. Yet people lapped up tales of patient management, lean processes and focus on costs to explain private equity success because the narrative fitted the returns available. Nassim Taleb’s book puts it succinctly: investors search for a reason to explain under/outperformance. A shame though that supposedly sophisticated investors get hoodwinked.

    The question now what happens next: with equity markets falling (exit routes closed), debt costs rising (refinancing becomes more expensive) and a general downturn (pressure on the companies), will the returns generated by leverage now get swallowed up by the deleveraging?

  4. Apr 01   15:28 Posted by VP [report]

    Not sure there’s much new here; has always been the case since the buyout days of Barbarians at the Gate.

    Buy it - gear it - flog it, job’s a good ‘un. And when the cycle turns & the debt’s unsustainable, it’ll be the new owners’ worry (pension funds, trackers etc: “not their money”).

    Made me wonder about the logic of the ideas for SBRY for eg.

    Most hedge funds seem to take a similar line - follow the trend, geared. Some of the gearing on some of the bust ones has been eye-watering. Shame really, as “true” hedge funds end up with a bad press.

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