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Private Equity’s Blind Bets on the Future

There are a number of ways to deal with unpleasant realities. One is to confront them head-on. Another is to let someone else handle them. And a third is – well, let’s call it the Scarlett O’Hara method: “I can’t think about that right now. If I do, I’ll go crazy. I’ll think about that tomorrow.”

When it comes to carried interest and portfolio valuations, it seems private equity investors are auditioning for a Broadway revival of Gone with the Wind.

We asked several PE investors and lawyers what they’ve been doing to prepare for the new regime of higher carried interest taxes, considering that they’ve had a full three years to think about the issue. One lawyer’s estimation was repeated several times: “The big picture answer is that a lot of firms haven’t done very much at all. There have been some efforts to do something about carried interest. There has also been a lot of resistance to those efforts.”

On the one hand, this shows that PE investors are being cautious and cost-conscious, in their way:
“I think that’s because most people don’t know quite what the legislation looks like until it actually happens. A lot of people have said ‘I’m not going to do anything planning until I know what the rules are. I’m not going to do something that costs money upfront.”

On the other hand, it should have been evident that the issue is not going away because Washington never stopped talking about it. Carried interest came up again in 2008, when the House wrote it into a bill; it came up in 2009, when the Obama administration started sketching it out only three weeks after taking office. The basic concept has remained the same despite a few cosmetic tweaks.

This “we’ll address it when we get there” approach doesn’t just apply to legislation. It also applies to valuation, where it could be even more destructive.

At last week’s Debtwire conference in New York City, panelists talked about the problematic new practice that has been helping to boost activity in private equity auctions and sales: Valuing private equity-owned companies on their forward earnings.

This means that PE professionals are selling- and buying- companies based on money those companies haven’t earned yet, and may never earn. Let’s call this the Wimpy model, after the cartoon character from 1934’s “We Aim to Please”: “I’ll gladly pay you Tuesday for a hamburger today.”

Valuing companies at forward earnings is something that the public markets do, and it’s bound to create trouble in the private markets simply because PE-owned companies carry more debt. Part of the lifespan of PE companies is to throw off enough cash flow to pay down that debt, which compromises earnings quality.

It may make sense to value a publicly traded company on forward earnings, because there is more visibility into its future. PE-owned companies don’t have that advantage, since they have many corporate changes ahead of them due to PE ownership – the success of inevitable cost cuts, the effect of new management installed by the PE firm, the possibility of leveraged recapitalizations that draw money out and, of course, the inevitable sale within three to seven years. Private equity-backed IPOs have to contend with the same challenges of outrunning the ghost of heavy debt.

If this practice is as popular as some PE pros say it is, it may be what accounts for the recent sales of some PE-owned companies at the eye-popping multiples much better suited to the 2006 and 2007 boom. While the economy has been troubled, buyout multiples have been soaring; Average purchase price multiples are now over 8.13 times Ebitda, according to The Deal. Partially that makes sense because financing is easier; until recently the junk-bond market was flying so high that it had an irrationally active year of its own. (peHUB described over the past two weeks the dangers of this “magical thinking” and why banks are fueling it.)

Mostly, however, paying high and selling low is not what anyone would call smart dealmaking.

Private equity’s willingness to buy into an optimistic view of “tomorrow” is not inherently bad – except when it hobbles the industry on legislation and in making correct valuations. This particular industry was always known for its hard-nosed realism and willingness to confront awkward financial facts such as failing companies and ugly debt loads. Private equity may be at risk of losing sight of the here and now.