This Wednesday's Wall Street Journal profiles
Stephen Schwarzman, the chief executive of Blackstone Group, a private equity firm. Blackstone is about to sell about 10% of its shares to the public, generating a huge windfall for Schwarzman -- and new public scrutiny of the private equity companies. From the article:
[Blackstone's] deals have accounted for more than a third of all merger activity this year. Blackstone has been especially active, sealing deals for big companies on both sides of the Atlantic. It manages $88 billion in assets, which makes it the world's largest private-equity firm. Last year, its fees, profits on deals, and other income totaled $2.3 billion, according to documents filed with the SEC.
For years, buyout firms have operated beyond the scrutiny of the public markets. But Blackstone's upcoming IPO and a public offering last year by KKR of an investment vehicle in Europe signal that the industry is expanding beyond its core constituency of institutional investors and reaching for more permanent sources of capital.
When private equity firms and hedge funds look into tapping public markets, that's a good indicator you should hold onto your wallet. Why? Well, think of it this way: when private equity lions lie down with the public market lamb, it's usually because the lamb is about to become dinner.
I had lunch with a friend of mine who recently been through a private equity deal. She said that one of the interesting bits was the relationships among the private equity companies themselves. While private equity firms were happy to buy public companies, reshape them, and then sell them again to the public, they were very reluctant to buy companies from other private equity firms. The mindset was pretty specific: private equity money is smart money, so buying from other smart money doesn't make any sense.
Private equity wants to buy and sell companies to public markets, because it considers public investors "dumb".I feel that there actually is a little truth to this point of view. Wall Street as a whole tends to run on a consensus (some would say a herd) view. Private equity companies, as illustrated by today's Wall Street Journal article, tend to be driven more by the visions and ambitions of a few individuals. The result: private equity is able to attack opportunities quickly and aggressively, without having to build consensus. That allows them to move ahead of the crowd, and if the opportunity eventually attracts the herd, then they have a large volume of buyers to sell to. Of course, if the crowd doesn't come, they're stuck with having to dispose of the their mistake too. That's why people like Mr. Schwarzman are paid the big bucks; they're not supposed to make too many mistakes.
But as we say in the engineering world, that's the steady state condition. The place where these systems break down is when they hit what are called "boundary" conditions, places where the old rules stop working. It happened once before with a company called Long Term Capital Management; it had Nobel prize winners like Fischer Black providing "can't lose" models for arbitrage. Worked great up until it had so much capital to invest, that it took huge positions -- as much as $1.25 trillion worth -- in international interest rate derivatives. Then the Russion government defaulted on its government bonds, and the efficient markets those models depended on broke down. [For a great read about the decline and fall of Long Term Capital Management, read
When Genius Failed: The Rise and Fall of Long-Term Capital Management
, available from Amazon. If you want the short version, the
Wikipedia summary isn't bad, but it lacks the color and drama of the book.]. The Federal Reserve Bank had to bail out the company, for fear that if it liquidated its positions, it would cause a complete melt-down of the US (and possibly global) financial markets.
We could see a similar crisis developing in the current flight to private equity. According to the Wall Street Journal, more than $170 billion of stock has been pulled out of the S&P 500 index this year due to private-equity-financed acquisitions and leveraged buyouts. A sidebar to the Blackstone article referenced above notes that
just the private equity deals in 2006 accounted for $700 billion in value. And in another WSJ article, it notes that the almost $1 trillion in hedge fund investments in 2006 is being used to manage $2.5 trillion in what the WSJ amusingly calls "bets" using derivatives. That $2.5 trillion is roughly 17% of the $15 trillion valuation of the US stock market according to
the Wilshire 5000 index. The bottom line: we're back in Long Term Capital Management territory and waiting for an event.
So what does all this doom and gloom about capital markets have to do with the usual things I write about?
Just this: all this private equity activity is one of the drivers of the current stock market boom.
The only reasons that private equity isn't buying up more of today's companies are that 1) there aren't enough companies to buy, and 2) there aren't enough good operators (read CEOs and other senior managers) to run them even if they could be bought. In short, what we face is a shortage of good business ideas and execution for private equity to buy out, not a shortage of money.
This is the reason I get excited about companies like Apple, that seem to create new ideas and markets from creative people; there are so few companies generating truly new ideas that when you see original ideas well executed, it's a real revelation. It's the reason companies like Twitter -- which has no significant revenue and no apparent business plan -- get funded; there are so few places for capital to get invested that nearly any half-way interesting idea can find money. And it's the reason that the stock market keeps rising despite most news and earnings data; as public businesses and stocks becomes scarcer, they becomes more valuable to people who have money to invest.
But the looming question is, now that private equity firms are turning to public markets for their own financing, does that mean they want out? And if private equity starts selling instead of buying, what happens to the public markets and the average investor?
Remember at the beginning of this article, I talked about how private equity firms really are there to buy and sell businesses from the public market. The assumption is that every property they buy, they'll be able to sell for more later. And private equity isn't going to sell those properties to other private companies -- they want to sell them to you and me, the "dumb" money that relies on and expects public disclosure and fair markets.
This process of buying to become private and selling back to the public works great when private equity is a small part of the economy and the public markets are a large part. But when private equity starts to manage positions that represent a significant percentage of the entire US public stock market, that process will become a lot less efficient simply because the public markets won't be able to absorb the private inventory. Said another way,
when private equity owns most of the valuable properties, how can the public markets afford to buy them out at a profit, especially with principal players taking billions off the top in management fees?The answer is that they can't, at least not all of them. And that's why Stephen Schwarzman wants to take Blackstone public now. He sees the herd mentality coming to private equity -- and when the herd arrives, it's time for the smart money to get out. He'll take his three quarters of a billion dollars now as insurance against that day when LBO'ed companies are as devalued as subprime mortgages are today. He'll cash out with hundreds of millions of dollars, but most investors and employees of the companies disposed of at fire sale prices will be asked to make sacrifices to turn their companies around.
Companies like Long Term Capital Management, WorldCom, Enron, and others have taught investors what types of businesses we get from cheap capital, easy leverage, and little oversight. Yet today's private capital trend is repeating the lesson for those who didn't learn from the machinations of Ivan Boesky and Michael Milliken in the 1980s. And it's becoming increasingly evident that it's going to be the public investor who's going to pay the tuition for those lessons.
UPDATE: A few similar articles to this one have started appearing in other publications. Richard Cooke penned an article yesterday titled
It’s Official: The Crash of the U.S. Economy has begun. In that article, he cites a cautionary screed by Steven Perlstein in the Washington Post titled,
The End of the Takeover Boom, and another by Robert J. Samuelson titled
The End Of Cheap Credit?:
Technorati Tags: Capital, Dumb money, Economy, Long Term Capital Management, Opinion, Private equity, Stephen Schwarzman, Smart money, Stocks, The Blackstone Group
