At first sight, the slipping prominence of private equity reflects the attention being given to two other segments of the financial industry: the struggling Westernbanks and brokerage firms who are still reeling from huge losses and the sovereign wealth funds that have given them $69 billion in capital in less than a year.
Yet as important as this two-sided relationship is—and it is important as the United States tries to avoid a recession that could affect other countries—it should not totally overshadow what is also happening to private equity. The industry has fallen on tougher times, with a recent spate of unraveling deals and languishing bank loans. Indeed, the worry is that private equity will become yet another falling domino in the global financial system.
Until recently, private equity was on a major bull run. And with that came lots of media reporting on some managers’ large paychecks, lavish lifestyles, and high-profile presidential-campaign financing. Private-equity firms had no problem finding lots of attractive targets among companies that had built up significant cash balances, in large part as a response to the financial dislocations experienced in 2002 (including the collateral damage to corporate balance sheets occasioned by the demise of Enron and WorldCom).
At the same time, credit was readily available. Moreover, after delivering superior investment returns for a number of years, some managers sought to capitalize further on the wave of public interest by selling part of their firms through an IPO, most notably the $4 billion NYSE debut of Blackstone last June.
The ascent of private equity had important systemic effects on the global financial system. Large purchases by leveraged PE buyers provided an additional bid for certain publicly traded companies. In turn, this led investors in general to push higher other companies and sectors that could eventually end up on the buy list of PE. As a result, private equity extended the bullish run in global equities, repressed market volatility, and inadvertently encouraged the stretching of a host of balance sheets throughout the U.S. economy.
Today’s general outlook for private equity is less rosy. While some firms such as Silver Lake have admirably sidestepped some of the recent potholes and excesses, the segment has gone from accentuating the bullish market mood to now being part of a self-reinforcing cycle of liquidity contraction, declining global equity valuations, and emergency policy responses in the United States and Europe.
There is less financing available to private equity for their deals, and what is available comes at a higher cost and with tougher covenants. Notwithstanding the fall in equity markets around the world over the past three months, opportunities have diminished as corporations face greater cash pressures on account of both higher costs (including those associated with the rise in commodity prices) and lower revenues (due to the slowdown in the U.S. economy). Evidence of the changed environment is apparent in share prices. Blackstone shares, which were issued at $31, are now trading below $18, representing a decline of over 40 percent in value in just over seven months.
Those politicians and CEOs who view private-equity managers as greedy asset stripping will undoubtedly welcome this change in fortune. So will politicians who have been wondering whether the sector was benefiting from preferential tax treatment. But such a reaction is shortsighted and serves to detract attention from the larger, complex chain of problems involving loss-making banks and brokerage firms, bankrupt mortgage companies, distressed bond insurers and collapsing structured-finance pyramids.
Fortunately, help is on the way. Aggressive interest-rate cuts by the U.S. Federal Reserve will, with time, start to offset the contraction in market liquidity and contain the increase in borrowing costs. The U.S. Congress has just approved a $150 billion fiscal stimulus package. And sovereign wealth funds, as well as other cash-rich entities such as Microsoft and Berkshire Hathaway, are helping to recapitalize struggling firms in the United States and elsewhere.
If accompanied by actions that stabilize the U.S. housing sector, this will prove enough to slow and eventually arrest the phenomenon of falling dominoes. But it will not provide instant relief to all segments of a financial industry that was seduced by financial alchemy, and convinced that unusually lax financing conditions would last forever. In the case of private equity, when managers re-emerge to take advantage of the growing set of market opportunities, as they undoubtedly will, they will likely do so on a much more solid footing albeit with some reduced reach and ambition.
