Where Are the Howls From Grantham’s Growls ?
Jeremy Grantham, the brilliant head of Boston based GMO LLC, published a piece last week that seemed to get overlooked at most places our browser frequents. We would love to see a spirited counterpoint to the the thesis he lays out, and the silence from the private crowd is leading us to our own conclusions about the ultimate sustainability of their business model and longer term prospects…
Private equity has existed for the last several years in a “perfect calm”. All the more important factors in determining success had become near perfect at the same time......
What has been almost completely missed, though, is the degree to which dazzling results have been enabled by rising global profit margins and leverage on easy terms. It is worth noting that it is the less efficient companies favoured by private equity managers that have had the largest rises in profit margins as they do in every cycle. Unfortunately, they also have the largest declines in the down legs.
This confusion of talent with temporary favourable conditions has combined to make clients willing to pay disproportionate fees. For example, in an unleveraged world the combination of the, say, 25 per cent premium required to buy a company in the market with the 2 per cent a year fee and the 20 per cent performance fee would completely offset a considerable 30 per cent improvement in the efficiency of a firm. FT
Is the jig up?
Perhaps the clues are embedded in the price action of Blackstone Group (BX-NYSE). In retrospect, the IPO was mis-priced. But the date of the event will remain fixed in the timeline of Wall Street’s history, and the onus is on the stock and the industry to prove the skeptics wrong. Although the industry is maintaining a unified front.
But the history of finance makes one point very clear: near-perfect conditions, although intrinsically very rare, are almost invariably extrapolated by market participants. Yet they almost invariably regress to more normal conditions.
When this regression happens to today’s record profit margins, all but a handful of private equity deals will lose money and many will lose it all. At a five-year horizon, even managers who could add 30 per cent to the efficiency of their firms would lose all their equity in highly-leveraged deals. More typical deals that add little or even detract value would of course do much worse.
And, economic and financial conditions may not stop at normal but, perish the thought, do the historically normal thing of over-correcting. Much hand wringing is now taking place over the consequences for private equity if a severe credit crisis were to occur. But the scary point I’m trying to make is that profit margins for companies owned by private equity will come back down under pressure from normal capitalistic competition. With or without a credit crisis, their geese are cooked.
But PE professionals have laughed all the way to the bank. The fortunes earned by even the lesser known private equity professionals will likely be sufficient to keep them knee deep in caviar and Krug until the day they die.
Grantham’s intellect is legendary, but I have found his consistently bearish posture to conflict with the pragmatic approach needed to survive the ups and downs of the financial markets. In the long run I am dead, and Grantham’s hand wringing over the years has been more food for thought than actionable information.
But this time I am with him. Although, I am in the midst of trying to figure out how to position myself. Too, words spoken by Dan Loeb well over a year ago continue to ring in my ears.
Dan Loeb does not suffer fools. And he might have been the first to press the button’s initiating the launch sequence…
During an informal question-and-answer session, hedge fund manager Daniel Loeb—seated in the audience—began to criticize private equity firms for hoarding profits that rightly belong to public shareholders. While some attendees may have agreed privately with Loeb, those dinner guests well accustomed to the sanguine navel-gazing of business conferences were taken aback. In the pantheon of audacious acts, Loeb’s behavior was akin to wearing an NRA T-shirt to a peace rally.
We might be late, but we are on the bandwagon, and remain short DealBook and DealJournal.
The silence from Private Equity equity crowd is deafening.
After the calm, private equity must now brace for the storms
Financial Times
Hostile Takeover
Men’s Vogue
Doldrums for Private Equity Backed IPO’s
Red Herring
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The content contained represent the opinions of 1440 Wall Street. This commentary in no way constitutes a solicitation of business or investment advice. It is intended solely for the entertainment of the reader, and the author.
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