The Private Equity Council today released the latest iteration of a long-term academic study on private equity’s role in the financial market. Not surprisingly, it finds that the industry does not pose significant risks to the financial system at large (particularly when contrasted to investment banks). Here are its six main points, with my gut reactions:
1. Efforts to turn around or strengthen undervalued companies represent a very unlikely source of systemic problems in capital markets.
I would agree, if only that’s what private equity was doing prior to the credit crunch. Instead, lots of firms (particularly in the large/mega markets) abandoned buy low/sell high strategy for buy high/sell higher. How many times did we see substantial premiums paid for public companies in the midst of a bull market? How many times did we hear: “This is already a market leader” or “This is a very strong company that we feel could be just a bit stronger?” Very few private equity firms were able to follow the sage words of Rudyard Kipling…
2. Private equity losses are unlikely to be of a cascading nature that could trigger a systemic event.
This point here is that PE transactions are financed with less debt than are bank investment holdings. And it’s fair, albeit damning with faint praise.
3. The character of PE investments is fundamentally different from those of leveraged financial institutions because they involve the acquisition of individual commercial businesses rather than financial instruments.
This is the point where the study’s comparative nature begins to grate on me. Let’s stipulate that PE isn’t going to cause the same types of troubles as Lehman did. Does that suddenly make them a source of market stabilization? My local mini-mart also isn’t going to cause the same troubles as Lehman did… Maybe someone should do a study on them. And, again, I go back to the changing profile of private equity investments. We’re talking some huge companies here, including Chrysler, Washington Mutual, Harrah’s, etc. If one of them fails, big ripples will be created.
4. Private equity funds occupy a place in the capital markets that is likely too small to trigger broad, cascading financial market problems.
Excuse me while I swallow my birthday cake (someone else’s B-day, but he left the cake here). Maybe true in the past, but not after the 2005-2007 buying binge… And before you tell me that I need to include 2000-2004 like the study does, please tell me how many of today’s busted subprime mortgages were signed prior to 2005. I know those are far more toxic than PE deals, but the broader point should hold: Private equity changed in character after 2004, and therefore so did its potential impact on the economy at large.
5. Private equity funds are diversified and have built-in protections from systemic events.
Legit point for the big funds we’re really talking about here, particularly in terms of the illiquid nature of limited partner capital.
6. Bank exposure to Private Equity is relatively small
The study says that banks, other financial intermediaries and insurance companies contributed a total of 29.5% of all PE fund capital. Not sure what that’s small in relation to. Now we might agree that lots of big PE firms should cut their fund sizes by 30%, but don’t tell me it wouldn’t hurt if they were forced to do so (staffing cuts, etc.). Plus, I really believe that lots of the new sources of PE capital – particularly SWFs in Asia and the Middle East – are going to be much more cautious going forward. In general, however, this item has more to do with the macro economy’s impact on PE than it does with PE’s impact on the macro economy.