Portfolio.com reports that regulators, subsumed with banks, hedge funds, and trading, have gone easy on private equity. Disciplining these funds is best left to institutional investors, anyway.
The private equity business is one of a handful of segments of the financial markets that isn’t emerging as a major focus for reform among Washington policymakers. True, there has been some discussion about taxing the industry’s profits at a higher rate, which is moving forward in the House in a proposal by Senator Carl Levin and Senator Max Baucus. But compared with the historic bank regulation that the Senate passed on Thursday, private equity funds and their managers have escaped the populist storm relatively unscathed, even if they will spend much of the next five years trying to refinance hundreds of billions of dollars of debt in a more difficult environment.
The probable reason for this relative immunity is that in their dealings with Wall Street investment banks, it’s more probable that it was the private equity world that took advantage of investment banks like Citigroup or Morgan Stanley rather than the other way around.
Indeed, within investment-banking circles, the biggest buyout shops—Blackstone, KKR, and Apollo—earned a reputation for playing one investment bank against another in quest of the cheapest and largest financing packages. At one point during the height of the frenzy, bankers at Citigroup were trying to find ways to finance a $85 billion buyout, several times the largest such deal ever done, on behalf of one of its clients. “We might have temporarily lost our minds,” admitted one of the bankers involved, after the fact. “But at the time, we knew we couldn’t afford to lose the client’s loyalty.”
Still, just because the private equity business seems to have manipulated Wall Street rather than the other way around doesn’t mean that it should be immune to scrutiny. True, its investors are sophisticated entities—pension funds, college and university endowments, and foundations. Many of them may have been encouraged by the success of early players like Yale’s David Swenson (and the latter’s loud cheerleading for such alternative asset classes) into committing extremely large chunks of their portfolios to the relatively illiquid private equity arena. The appeal was easy enough to understand. At the height of the private equity boom, top quartile firms generated an annualized return of 39 percent, according to the Private Equity Council, an industry group.
A survey last year by Prequin calculated that two out of every five of the largest endowments have allowed or encouraged their allocations to private equity to exceed their targets, signaling a dangerous lack of discipline on the part of those institutions. But that wasn’t because Wall Street misinformed or concealed the true nature of the risks or return characteristics of private equity from these investors, as numerous legal actions now claim was how Main Street homeowners ended up refinancing their homes with toxic mortgages or German banks invested in CDOs.
On the contrary, the terms of the deals being struck by buyout funds at the height of the bubble often were spelled out in newspaper headlines. It was all too clear that these often involved miniscule amounts of equity investment and massive debt loads.
It’s not surprising that those chickens are coming home to roost. In March, Moody’s Investors Service released a much-buzzed-about report, one that aroused the ire of the private equity world from the very first sentence: “Nearly half of U.S. nonfinancial corporates that defaulted in 2009 had private equity sponsors.”
In other words, those debt loads were making it difficult for the companies that had been buyout targets to function and repay that debt in a recessionary environment. One after another well-known companies filed for bankruptcy protection, staggering under the burden of debt loads applied to their operations by new private equity purchasers: Linens ‘n Things, Reader’s Digest Association, Tribune Co. (the publisher of Chicago’s broadsheet daily newspaper.) The bigger the buyout, the more perilous the outcome, Moody’s said, and the debt rating agency pointed to high correlations between low-rated debt issues and defaults, and between buyout-backed companies and low-rated debt issues.
The Moody’s report, coupled with others from the Boston Consulting Group and Standard & Poor’s—all suggesting that the pain isn’t yet at an end—have been met with furious ripostes from those inside the buyout world. The issue under debate appears to be the precise definition of a default: Moody’s lumps negotiated settlements and prepackaged bankruptcies into the default category, while other studies (including one sponsored by the Private Equity Council) argue that it’s inappropriate to include transactions in which bondholders received significant “recovery” levels on their investments.
That strikes StreetWise as debating over how many angels are capable of dancing a creditable flamenco atop the proverbial head of a pin. Rather than debating whether recovering 80 cents on the dollar means a bond didn’t technically default, the private equity industry might well start spending some time revisiting its basic model and questioning its relationships not with Wall Street (which will always bend over backwards to accommodate such lucrative clients) but with their own investors and the management of their portfolio companies they acquire.