McKinsey's Response Underscores Private Equity's Decline

Interesting stuff. In an article published last week at Slate (ht Barry Ritholtz), Daniel Gross takes issue with a McKinsey & Co. report about the The New Power Brokers (see McKinsey’s Cracked Crystal Ball). Gross criticizes McKinsey for offering inaccurate predictions with respect to the rise of private equity funds and hedge funds. Gross writes:

In October 2007—the precise market top—McKinsey Global Institute, a think tank nestled in the confines of the blue-chip consulting firm McKinsey & Co., issued a report documenting the stunning rise of four comparatively new pools of capital—hedge funds, private-equity firms, Asian sovereign capital (Asian central banks and sovereign wealth funds), and petroleum exporters (companies, governments, and central banks of oil producers). These new power brokers had been major beneficiaries of recent trends in the global economy. And if existing trends were to continue—and why wouldn’t they?—they’d be even bigger in a few years.

As the executive summary noted (here’s the whole report), in mid-2007 that group collectively held $8.4 trillion in assets, more than triple the amount they held in 2000. But that was just the beginning. “Under current growth trends, MGI research finds that their assets will reach $20.7 trillion by 2012.”

Like virtually every professional economic-forecasting outfit, McKinsey’s crew failed to see how the easy money created by the rise of Asian sovereign wealth and petroleum exporters would be put to spectacularly bad use by private-equity firms and hedge funds…Of course, you don’t have to be a management consultant to know that simply projecting recent trends into the near future—forecasting by extrapolation—is dangerous, especially today, when volatility and discontinuities are rampant. A scant two years ago, MGI’s brainpower was unable to foresee the forces that would cause hedge funds to take a tumble and private-equity deals to blow up.

The interesting thing to me about Gross’ piece is not the criticism of McKinsey. It is not even that McKinsey might have been off in its prognostication. The most interesting part was that the article elicited a response from McKinsey. Why McKinsey would feel threatened by the piece is beyond me. It’s not like the piece does irreparable harm to McKinsey’s reputation.

Nevertheless, Rebeca Robboy, the media representative from the McKinsey Global Institute, responded in the comments section on the Slate site. She writes:

Dan Gross is entitled to disagree with our conclusions, but not to misrepresent our research…

First, Gross wrote that our original 2007 report “utterly failed to sniff out the systemic risks” posed by the rise of these four increasingly large and influential investor groups. In fact, and to the contrary, our report explicitly noted that the “the rise of the power brokers also poses new risks to the global financial system.” We noted specifically that the surplus capital invested by oil exporters and Asian sovereign investors was lowering interest rates and “may be inflating some asset prices and enabling excessive lending” and we highlighted real estate as an area that warranted concern.

Second, Gross fundamentally misrepresents our work by stating that we assume that recent trends will continue into the future.

Third, he errs in calling our work “forecasting by extrapolation.” We are not forecasters. We have reported the facts based on proprietary databases, and our analyses of future trends under three proprietary macroeconomic scenarios.

SIDEBAR: Call me crazy, but with respect to the third point, doesn’t “analyses of future trends under three proprietary macroeconomic scenarios” qualify as a forecast? Am I missing some semantic subtlety?

Anyhow, I still find it interesting that McKinsey felt compelled to respond to Gross in a public forum. Although I am sure their response was in the interest of setting the record straight, it comes across as overly sensitive, borderline desperate. C’mon, this is McKinsey we’re talking about, the Goldman of consulting. They need not have responded.

For the record, I have been writing about private equity funds for quite awhile. By the end of 2006/early 2007, it was patently obvious to most that hedge funds and private equity funds were in decline. In fact, in April of 2007, in a post entitled Private Equity – Stupid Money Chasing Stupid Deals, I wrote:

I do believe that the increasing number of private equity deals of late is an exemplar of excess…I refer to this as the phenomenon of stupid money chasing stupid deals…will all these ventures be successful? Likely not. With most private equity firms flush with cash as a result of the global liquidity glut (caused by historically low interest rates and a change in attitudes toward risk) and with only a finite number of targets to buy, increased competition among LBO funds (and industry acquirers) for the same handful of firms has led many buyers to overpay. Moreover, with creditors offering enough debt to hang oneself with, many targets will become overextended.

I followed that in March of 2008 with a post about the end of the private equity era (see Private Equity: The End of an Era). I wrote:

If anyone thought that private equity acquisitions were driven purely by skillful strategists and financiers (alpha in their parlance), here’s your evidence to the contrary. Many such deals were a simple product of the times (fueled by the availability of cheap money and credit). This is not to say that some private equity players are not skilled, just that there are likely much much fewer of the skilled type than many of us had thought just as little as one year ago.

Frankly, I have expected this endgame for quite awhile now – one in which many of the private equity portfolio companies would go bankrupt, and potentially take a few of their parents with them…

But more than that, for me, these events officially mark the end of an era. We will likely look back at this period and eventually refer to it as the second LBO wave. In my opinion, there are now two identifiable, and distinct, LBO waves:

1. The 1980’s – the wave that most of us associate with the LBO heyday; driven by the break-up of conglomerates, culminating with the RJR Nabisco deal, and etched in our memories by the movie “Wall Street”
2. The 2000’s – the cheap money wave; fueled by excess leverage, cov-lite deals, financial engineering, and a dose of Sarbanes-Oxley compliance avoidance

CAVEAT: None of my writings about private equity qualifies as a forecast, …simply reporting the facts based on proprietary databases, and my analysis of future trends.

Disclosure: No positions