One of the things you must understand is the danger in attributing intelligence to the simple fact that people are associated with large sums of money or large financial operations. We don't ask whether they're intelligent. We say, they're associated with all this money, so they must be intelligent. We attribute intelligence to association with financial operations. And only afterwards do we discover that error and that the people involved can be extremely successful in gulling themselves. That they can be in effect, and I use the word advisedly, marvelously stupid.
--John Kenneth Galbraith
I've used this Galbraith quote before but it is so prescient across many themes this cycle that a reminder is in order as I fear this private equity cycle is going to end badly. In fact, I believe a contributing
factor (not primary) to the recent equity market rally, albeit narrow, is because banks need time to clear the massive amount of private equity related garbage off of their books. (The vast majority of 130-odd subsectors are underperforming this rally and as I wrote last Friday, stocks are significantly underperforming the weighted averages.) How are banks to do that without painting the appearance that fundamentals are back to normal which they clearly are not. Remember, distribution to weak hands from strong hands happens at market peaks. That includes not only equities but also debt accumulated in various financial instruments and deals. This cycle, the weak hands are comprised of major non U.S. investors as much of the mess is packaged in such a way that individuals aren't able to eat it as they did with technology stocks in 2000. That is, except through pension funds and retirement plans buying Wall Street's toxic waste. As part of the me-first generation, I find it heart warming that anti-democratic sovereign funds from Russia, China and the Middle East are willing to step up and eat the dog food. A little quid pro quo for the tainted dog food they've been shipping us. (Some misplaced humor.) My point is Wall Street is going to do everything possible not to be left "holding the bag"
As recently as a few months ago many Wall Street personalities were rabidly chasing equities based on their takeover potential. No one was more involved than Goldman Sachs and other big financial firms pumping takeover candidate lists for equity investors. I'd be surprised if these institutional trading arms weren't benefiting from said pumps. I am quite confident Benjamin Graham
is turning over in his grave at this latest of foolish behavior. And that list of foolishness is longer than it has ever been in my life time. Much longer than in 2000. The equity markets have truly achieved gaming status. All while underlying fundamentals have been very weak for quite some time. But, this time rather than it being the public that has been duped, it is the market professional who is manic. Don't think a little market weakness over one month fixes the excesses built up over a generation. Not even close. Gambler's Anonymous anyone?
First let me say that private equity has many forms and has many functions. Some incarnations are beneficial but many are not in my estimation. In other words, I am quite dubious as to much of the praise heaped upon private equity and we are going to talk about why that is. It was nearly impossible for private equity not to make money in acquisitions in the 1980s and 1990s. Here's why. The entire equity universe saw valuation expansion over that twenty year period. As an example, let's take the S&P 500 which went from a PE of about 7 in 1982 to over 40 in 2000. Therefore, as investors bid up stock valuations, it was nearly impossible not to print money by taking a company private and then public again in a three to five year period. Even if the company's fundamentals and profit picture didn't improve one iota. The voracious hunger for stocks at any price made billions for private equity regardless of whether any fundamental value was actually created by their investment. Additionally, we have been in an environment of sustained inflation over the last few decades. So, if nothing else, again taking a company private and then public a few years later guaranteed that asset rose in value from inflation alone. For those two reasons, anyone with access to capital was nearly assured of making a tremendous amount of money playing this game. The genius of private equity or the sheer luck of being in the right market at the right time?
Today's markets are very, very different. I have written repeatedly about the devil being deflation and not inflation. My views have remained consistent because of what I believe is coming to pass in the global economy. None of the current crop of private equity crew or their bankers have any experience in this environment. An environment that will likely be one for the text books. Therefore, private equity investments are going to be tested like never before and we'll truly find out about the genius of private equity.
The core competency of private equity is more about salesmanship and the ability to raise capital versus operational management expertise, understanding the macro dynamics under which they operate or the implications of those dynamics. Private equity built up a nearly invincible reputation over thirty years and I would argue that fundamentals discussed above were the largest contributor to that reputation as opposed to actually adding intrinsic value to businesses they bought. These fundamentals no longer exist. We have likely reached a point where what worked last year or last decade will not work on a go forward basis in many regards.
As someone who has done a fair share of return on investment analyses for major projects and investments, I believe the financial dynamics of these private equity deals look incredibly foolish from an outsider's perspective. Potential problems include deflation, tighter credit, peak earnings and major debt loads working in tandem to create ongoing headwinds for debt laden private equity deals done over this business cycle. This isn't rocket science. Of course, we are finding out bankers and financiers aren't to be confused with rocket scientists either. If you can balance your check book, you can understand what private equity has been doing. As a generalization, the dynamics driving the private equity market can be summed up in one sentence; Long term borrowing rates were cheaper than the earnings yield on stocks.
That's it. Sounds really simple? That's because it is. As long as I can borrow money at very attractive terms/rates and earnings yields are great, these deals are possible. It's the exact same
dynamics as the housing mania applied to stocks. Long term borrowing rates were cheaper than the yield on a real estate flip. That is, until the real estate markets were priced beyond what fundamentals could support. Wasn't it exactly at this time that everyone piled into the game? Homebuilder CEOs became CNBC rock stars, (thank you CNBC for your insightful journalism) record numbers of real estate agents, record people flipping houses, record companies building condos, record mortgage businesses with loose terms, magazine covers and on and on. Still dubious of the skyscraper indicator? Who needs an industrial economy, we'll all flip homes for a living. What does any of this have to do with fundamentals? The same can be said about private equity. Too much stupid money chasing alot of really bad decisions.
The majority of these M&A and private equity deals were done with debt. Lot's of debt. Record debt with minimal equity. Much more debt that anything unfolding in the subprime housing markets. By the way, private equity has scooped up its share of subprime investments even though the global real estate situation is still worsening. Another foolish move? Every person who understands basic finance will tell you that deals done using higher debt ratios should involve more stringent litmus tests such as a higher hurdle rate.
There is higher risk and a higher cost. But, I am confident there are no such discussions being undertaken when these firms are seeing massive deal takeouts adding significantly to their personal wealth. It's more like let's get the deals done before someone wakes up to reality. Banks were falling all over themselves to loan money to private equity with ridiculous terms. Here's the insanely idiotic
problem with these deals. Because earnings were awful in the stock market rout of 2001, 2002 and early 2003, these deals weren't possible at that time even though companies could have been bought for 30, 50 or 80% less. So, although these deals could have been done with 30, 50 or 80% less debt than deals done over the last few years, the lending dynamics weren't conducive to doing deals. Instead these deals are being done at peak earnings cycles with peak debt and premium valuations not seen at any time in history. What does this sound like? That's right. Again, it's the real estate situation or the 2000 technology bubble redux. Private equity is smart money? Many of these deals have so much debt that they should be called public debt and not private equity. Guess where private equity is getting the debt to do these deals? Your friendly banker has been throwing money at private equity. That would be your deposits. Your money. The same banker who is supposed to be held to regulatory standards because your savings are parked there. What a surprise. Still think the problem is the American consumer? Uhhuh. A consumer led recession? Hardly. The world's consumers will indeed bear the consequences but not the blame for this cycle of madness. All while the instigators walk away with billions.
Here's another problem that will compound the private equity mania. Private equity has traditionally not been a source of operational talent able to actually manage businesses. Adding insult to injury many of the executives of the acquired companies cash out as they are effectively bought in order to agree to the deals in the first place. That leaves large leadership vacuums at many of these private equity deals. As Larry Bossidy, one of the best operational CEOs of our time, has said, "Private equity is good at raising money. Not good at running businesses.". Ironically, private equity has hired Bossidy as well as other retired CEOs as consultants. Yet, I can assure you, that does not mean Bossidy is running daily operations. Most of these hired consultants are enjoying lucrative retirements. It's sort of like Lehman who just hired President Bush's brother. It's more about putting lipstick on a pig to sell the package to politicians and bankers. As an aside, this schtick of taking companies private to alleviate the pressure of being public is a complete farce. Look, if you don't have a long term strategy and cannot manage a company to that long term strategy while showing progressive improvement to your plan in the intermediate term, you are likely one of the 80% of CEOs that shouldn't be a CEO. And, you aren't going to be more successful by implementing the same plan as a private company. Arguably without shareholder and board oversight, the opposite could be true. There are very little, if any, tangible benefits to being private. If there were, why aren't all companies private? As Alan Mulally the CEO of Ford recently said, "Chrysler has no advantage by being private in a turnaround effort.". Of course we already knew that since both Toyota and Honda are both public companies as are the majority of the world's best run organizations.
Let me share some factoids of a deal I'm familiar with. A big private equity deal was done some time ago and I knew one of the sales executives at the company being bought. The CEO of that company cashed out and retired with the massive cash he was given as part of the deal. Immediate management vacuum. In addition, I'm quite sure that cash out was simply added to the company's debt. Debt that reduces the company's cash flow and might ironically lead to needing access to more capital in the future. That means this company is more reliant on what? That's right. The roiling credit markets that will likely remain tight or worse for years. The private equity firm immediately instituted unproven and destructive changes to the sales compensation process and created an unwieldy bureaucracy which made it difficult for the sales organization to be successful. Mind you, this was a company that was a leader in its field. These contributing factors have led to a drop in business results. My contact has since left the company and the turnover in the sales team has ballooned to around 50% due to dissatisfaction with the new management style. Another management vacuum. This is a business where individual sales are tens of millions of dollars, extremely complex, involving up to dozens of consultants and very competitive. Therefore, the sales team is a life blood to this organization. Finding qualified people in an organization with highly sophisticated, complex multi-million dollar deals is difficult in itself. The profile for sales executives in this type of organization is one of overachievers, complex thinkers and self-motivated business executives in their own right. Disruptions in the sales force can literally decimate business results as client trust and relationships are built over a period of years if not decades. It sounds cliche, but the workers truly are the primary asset of any successful company. Dealing with the loss of intellectual capital associated with a high powered sales team can and likely will create a death spiral. How will this grand experiment end? It's not looking good and I seriously doubt this is an isolated example.
Isn't it just like humankind to take tremendous risk just as a trend has changed? Can you say 1929 and 2000 in the U.S. & European equity markets and similar experiences at different times in Japan and now China? Are bankers and private equity really any different than the masses or are they susceptible to the same behavior as the rest of us? In fact, they are the rest of us. That is why I have long argued bankers need oversight to protect us from those that would be fools without said oversight. Effectively, we need to be protected from ourselves when it comes to our monetary system. Failures can be constructive and a positive part of any free market system except when it comes to the monetary system. If private equity were truly private, they wouldn't need oversight. But, private equity has become public money. I don't work in the private equity industry so I'm not privy to what the dinner table conversations are but I suspect many old timers knew very well this cycle was going to end badly yet it didn't stop anyone from doing deals. If you are paid to make deals happen and the dynamics that allow you to take advantage of a once in a life opportunity is, what do you do? As most anyone would do in a bubble, you likely feel invincible and take incredible risk as you see deals minting tens or hundreds of millions of dollars of personal gain. Can we really blame private equity for doing what the system is allowing them to do? No more than we can blame investors participating in any mania. Today's version of capitalism still reeks of greed from the 2000 equity bubble, 2005 housing bubble, 2007 commodities bubble, 2007 hedge fund bubble, 2007 equities bubble and 2007 private equity bubble. Anyone who believes sentiment after a minor correction lasting a few weeks somehow points to the start of a new bull market are themselves consumed by bubble mentality and not thinking rationally.
Capitalism was not always nor will it always be this way. Will there always be greed? Sure. And that isn't bad on a certain level. But there will also be a return to rolling up our sleeves and creating a legacy of success by building businesses to be proud of while creating value in doing so. We are closer than many believe to returning to that point. And, it will likely be a forced march. In other words, not initially by choice. Societal values change over time and the mentality of the masses is reflected by a change in those beliefs. We are at the end of a very long cycle where we have been bombarded by social messages to believe today's behavior is normal and acceptable. Partially so that those who are able to take as much as possible can actually do so. But as I wrote last year, "Never have so many relied upon so few.".
If for no other reason than that fact alone, we are seeing a major sentiment shift. And, those at the top are always the last to realize something has changed in their insular view of reality. In the mean time, someone is going to eat a dirt sandwich on many of these deals. That someone will likely be global shareholders, pension funds, consumers and the general public.
The aura of private equity is indeed a myth.