Private Equity - House “Flipping” for MBA’s

Bias Disclaimer: Please refer to the post on my biases if you wish to read this post without having to guess where I am coming from.  In addition I will put it out on the table that I am very skeptical of Private Equity.  Something about it irks me and it may just be the "private" nature of it but I believe it is something more. 

 

Private Equity is Global Liquidity's tragic offspring.  Global Liquidity has been sloshing around for years now producing housing booms, energy booms, art booms, and many other booms/bubbles alongside many mates – go ahead call it a whore.  One child that that came out of this lovely marriage between Global Liquidity and Investment Banking was Private Equity.  Private Equity grew up on the school of thought that the Public Equity markets were oversupplied and that companies come along that could be priced better if brought private, loaded up on debt, put through a dramatic cost cutting campaign, then repackaged and sold to other investors – with hopes that the enormous leverage undertaken would payoff.  As it grew, Private Equity became very close with its father – Investment Banking.  Investment Banking took it under its wing and offered it access to debt, markets for its newly transformed firms, and streams of capital from both high end retail and its brokerage clients.  Investment Banking reaped great profits on Wall Street, making a ton of money advising Private Equity, then providing the lending facilities to finance its favorite pastime – leveraged buyouts.   Private Equity, being well fed and taken care of grew and grew and eventually became a self fulfilling prodigal son.  As more and more Private Equity came around, Public Equity markets rose – causing the overall market for Equity in general to be great.  Private Equity made headlines performing bigger and bigger leverage buyouts and accumulating more and more Public Equity, driving that market higher and higher.  Daddy was happy as he was becoming richer and richer, Mommy was off producing more little booms and bubbles, and everyone lived happily ever after……

I wish the very stupid and poorly written fairy tale above was true, but I don't think it's going to end so well.  More likely – Mommy abruptly dies and Daddy – unable to cope with the loss, let's Private Equity shrink until he is small enough for Daddy to eat.  Not your Mother Goose ending – but those endings were always lame anyways. 

I believe Private Equity, in today's form, is a major Ponzi Scheme orchestrated from the desk of Investment Bankers struggling with the fact that with SarbOx in tact the IPO market in the US will never be the same.   It is no different than the IPO market of the late nineties.  Maybe I am not in tune with what happens, or maybe the "private" nature of Private Equity hides the transactions but I have seen a wave of buying lately but no sales.  There hasn't been as many Private Equity IPO's as there was a few years back.  With the Private Companies out of the spotlight you begin to wonder if they are catching a bid. Roger Ehrenberg on Information Arbitrage mentions an exchange that Goldman Sachs has put into place.  I know nothing else of this exchange but I believe it is more of a selling point for new Private Equity business than it is a viable exchange that will support trading of these assets.

  I don't believe it has gotten bad or even looks bad to most yet.  I assume the abundance of Liquidity is facilitating transactions between Private Equity Firms and different investors.  I assume that the economy and low financing they got through their incestual relationship with Investment Banking the past few years have allowed firms to survive on the cash flows and make profits for their investors, don't buy the fact that they will be able to "flip" these companies as planned.  It is eerily similar to real estate "flippers" at the end of the housing boom – bidding up real estate with access to cheap debt all along maintaining the idea that they can fix up the place and sell it later at a profit.  They perpetuated the boom in houses until of course it became a bubble and popped.  At its very core, Private Equity is no different and that is a scary thought.

I would like to moment look at the Risks and Implications of a Private Equity collapse. 

Risks

1. Liquidity Risk – A major source of capital for these funds is wealthy investors.  Many people who have dealt with this group of people will know that these individuals are usually sophisticated, have a short term memory, and are somewhat conservative when they believe they have obtained a sizable enough gain.  I believe Private Equity could collapse spectacularly if exposed to a widespread liquidation.  Ask a hedge fund manager who blew up how difficult it is to sell a position in a relatively liquid, standardized derivate contract when forced to unload a large position, and think about how difficult it would be to unload shares in a huge corporation that require much more time and delicate handling.  If Tidal wave is perceived to hit New York I guarantee self inflating rafts will be much easier for Modell's to unload than ones that have to be blown up manually – even if they are better quality and more likely to get you out of Manhattan alive. 
2. Credit Risk – These companies are highly leveraged.  Any slowdown in the economy poses a great credit risk for them.  These companies are targeted because of their ability to generate cash flow.  The "theory" is that a company with that ability will not have a problem paying interest expense on the loans outstanding, and in turn buy some time to really cut down expenses and increase earnings.  Without the ability to catch a bid and decreasing cash flow – credit risk becomes a real concern.  Much like in the subprime loan scandal – the availability of derivatives, perceived lack of risk, and comfort of getting the credit risk off balance sheets has promoted lax lending.  Credit default swaps and other credit securitizations are Private Equity's version of Mortgage Backed Bonds.  Just because risk has been transferred does not mean it no longer exists.  If I am a used car salesman selling lemons to customers, even though I am no longer sitting on the lemon I am still sitting on the risk that selling a lemon entails – lawsuits, decreasing sales, business failure, as well as the possibility that my increasing car sales for the last few years has caused me to be overly ambitious in the inventory I am sitting on.
3. Political Risk - Up until now, Private Equity has been relatively untouched from regulation.  I can imagine the first smell of weakness will bring about regulation and the regular cast of characters.
4. Market Risk – A broad-based Public Equity Market decline will hurt the market for private equity.  The difference? Private Equity is much more leveraged. 

 

Implications/Possible Outcomes

1. The perpetual "Private Equity Bid" that the public markets have been catching the past year will disappear, fueling a market crash
2. Investment Banks will fall victim to the same type of sub-prime defaults but on corporate scale.  More likely, they will become owners of many of these businesses
3. A credit crunch could permeate throughout the financial system tightening up leverage for hedge funds and fueling a spectacular asset liquidation event. 
4. An IPO blitz like in the late 1990's but will see offerings plummet post-issue as retail investors are mostly invested in ETF's and diversified allocations – not individual stocks and institutional investors are smart enough to stay away. 
5. Massive layoffs from these private companies, putting a damper on the economy and our GDP. 
6. Government Rescue Mission orchestrated by Treasury and major Banks through the Repo market – giving Banks the liquidity to buy these companies.
7. I am completely wrong and Private Equity continues to return 30% a year without any major corrections (threw it in to be fair). 

Now, this is all just speculation on my behalf and anyone with some inner knowledge of what's going on please feel free to correct me or add to this.  I would be interested to know.  But the spooky similarity to both the real-estate "flipping" boom/bust and the risk "blindness" of the subprime boom makes me believe that we will see this in the coming months or years.   

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