VideoIN MOST financial crises private equity is part of the problem. During a typical credit cycle it is among the first to use cheap financing to buy companies. Buy-out firms gradually become trigger-happy, overpaying and loading businesses with so much debt that some of them go bust. After the crash, the industry is in disgrace and skulks away to bind its wounds. Years later it returns, penitent, wiser—but hungry once again for cheap loans.
In this financial crisis, however, private equity thinks it is part of the solution. Buy-out firms have struck lots of dodgy deals, certainly, but they are still rich and ambitious. And amid the financial wreckage of the credit collapse, private-equity partners think they have spotted a chance to make a lot of money by helping Western banks to repair their tattered balance sheets.
This strategy partly reflects private equity’s fund-raising before the credit crunch. Back then, pension and sovereign-wealth funds were not just sipping the buy-out Kool-Aid, they were swigging gallons of the stuff. As a result buy-out firms still have almost $450 billion of their cash to invest, according to Preqin, a research firm.
The boom also fed buy-out firms’ aspirations. No longer are they content to act as Wall Street’s vigilantes, picking off the weak and the stray. Most now have high fixed costs, in the form of hundreds of employees. Their ageing founders long to diversify their firms and propel them into the top ranks of the financial establishment.
So private equity has the ambition to rescue ailing banks and it has the money. But does that make it a good idea?
A brief history of timing
To understand how private equity reached this position, consider the long-term prospects of leveraged buy-outs (LBOs), its core business. In 2006-07 the industry binged, buying companies with an enterprise value of $1.4 trillion. After adjusting for inflation, that is the equivalent to one-third of all the LBOs ever. Denial and rose-tinted accounting mean that losses on these investments have yet to be fully recognised. But the shares of listed buy-out funds are trading far below their book value and some clients, anticipating losses, are reportedly considering off-loading their interests in LBO funds.
The academic evidence for the private-equity industry’s historic returns is unclear. After fees and adjusting for leverage, the industry’s performance is similar to that of publicly listed shares (given that both asset classes own companies’ equity, this should not come as a surprise). But the poor deals at the top of the market could skew private equity’s record downward.
Optimists argue that credit markets will eventually recover. They also point out that the fall in stockmarkets means more bargains are available. Yet that is for later. In spite of all the equity it has to invest, the buy-out industry cannot now raise the debt it needs for large transactions. The banking crisis and sickly markets mean that there are no big loans to be had.
In any case, lower stockmarkets must be cold comfort to big clients like pension funds and sovereign-wealth funds, which saw private equity spend their cash at the top of the cycle. The shadow cast by those boomtime deals is one reason why, even if credit conditions improve, big clients may view LBOs with jaundiced eyes.
Private-equity firms could always hand back their clients’ cash. That may yet happen, but they have every reason to resist. Many, including Kohlberg Kravis Roberts (KKR) and Apollo, plan to follow Blackstone and list their shares. That is hardly the time to be shrinking the assets they manage. In addition, a chunk of their fees is usually charged as a percentage of the capital they manage, regardless of whether it has been put to work. And most firms lock away cash for roughly a decade in funds that typically need a supermajority of investors to unwind them. Clients are complaining, but not that much.
This leaves a neat coincidence. On one side of the financial system are buy-out firms with ambition, long-term capital, discretion about how to invest it, and a dearth of opportunities to invest in industrial companies. On the other are banks, desperately short of capital and liquidity. It does not take a billionaire buy-out barbarian to put two and two together.
So buy-out firms are redirecting their buy-out funds towards financial assets and they are also raising new funds. Preqin estimates that a further $40 billion of new distressed-debt funds is waiting to be deployed. At the same time, big firms have been adding to their credit teams by buying fixed-income talent. In January Blackstone bagged GSO, a distressed-debt-management firm. Credit has already become a big part of the assets the leading firms manage: between a quarter and a fifth for Blackstone, KKR and Apollo.
Understandably, the first deals with banks have been close to home. Most buy-out firms have started by buying the distressed loans that banks issued to fund LBOs, many of which trade at 70-80% of face value. Only a few big deals have been made public: Citigroup’s sale of $12 billion of debt to TPG, Blackstone and Apollo, for instance. But behind the scenes the activity has been frenzied.
Chris Taggert, of CreditSights, a research firm, estimates that the overhang of LBO loans that banks are waiting to sell on to investors has shrunk by $192 billion from the peak, to just $45 billion today. That chimes with the banks’ own disclosures. An analysis by The Economist suggests that the amount of corporate junk debt on the balance sheets of ten of the largest banks in the loan markets had fallen by $205 billion, to $163 billion at the second quarter.
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