Private Equity as Footwear

Is private equity the next financial shoe to drop? That’s the question answered affirmatively by Doug Kass over at, and then seconded by Jim Cramer (Cramer vid at bottom).

None of what Kass argues should be terribly surprising to readers of this space, but the very existence of his argument may portend a revival of private equity as public whipping boy. It might have to wait its turn behind the credit card companies and hedge fund managers, but there certainly would be plenty of thong and cracker left for the onetime kings of capitalism.

The Kass case is basically that private equity firms binged on leverage, and that the repercussions will be devastating both for the firms and for their investors. That latter class is particularly vulnerable, Kass says, because illiquid private equity investments “will result in a crowding out of inflows into other alternative strategies.” Kind of the denominator effect’s flipside. Kass doesn’t explicitly say it, but he hints that LP troubles would have a trickle-down effect to the economy at large, because so many of them are public pension systems, corporate pension systems, charitable foundations and the like. And then there’s the looming threat of leverage-burdened companies laying off employees, or shutting down altogether.

I don’t disagree with any of the argument’s basic tenants. In fact, you might recall me writing the following back in October 2006, after Penguin Publishing inked Sarah Lacey to write a book about Silicon Valley:

My own book deal will be signed… well, whenever I can find some free time to begin writing a book. How about: “Fortunes Lost: How Mega-LBO Firms Nearly Bankrupted America’s Public Pension Systems.” It’s a forward-looking piece…

I do, however, have a big quibble on the issue of degree. If private equity is the next shoe to drop, it’s only a sneaker compared to the lumberjack boot of real estate. That’s not to say private equity failures won’t have some devastating effects, but it (luckily) just doesn’t scale to the same extent.

Kass doesn’t seem to ignore the issue of degree in order to ease his argument, but rather because he has an poorly-defined view of the private equity universe. For example, he writes:

Like post-2005 vintage mortgage lending, most private equity deals done over the last two and a half years (estimated at over $100 billion) are now worthless (as are some of the early vintages). Unfortunately, those unrealized losses have not even been reflected in the marks of private equity investors (including many hedge funds) around the world, who are likely to see their own Black Swan event in the near future.

First, his $100 billion figure is way to low for private equity volume from 2006 through to the present. Thomson Reuters puts the number at $475 billion for 2007 alone, which really makes me question his source (it’s not cited).

More importantly, I have seen no evidence that “most” private equity deals done in that timeframe are now “worthless.” It is true that the equity has been squeezed out of mega-LBOs, and that it exponentially increases the likelihood of failure. But some of those situations can and will be turned around, while others will simply become mild ROI losers rather than catastrophes. And we must note that there have been some positive exits from the class of 2006. Not many, but some.

In short, I’m also very worried about what private equity may hath wrought. But I’m not apoplectic, becuase I see enough good sprinkled in with the bad.

Watch Cramer: