The Coming Crises in Private Equity, Hedge Funds

by: Yankee Group

By Carl Howe

I noted back in June that when private equity companies such as Blackstone Group (NYSE:BX) want the public's money, it's time to hold onto your wallet. Why? Because it means they've exhausted their sources of "smart" money. And if they go looking for "dumb" money, it means they are heading for the exits.

Well, yesterday's New York Times notes that esteemed voices such as Michael Jensen, the Harvard business school professor emeritus and the father of private equity, are sounding a similar alarm:

“We are going to see bad deals that have been done that are not publicly known as bad deals yet, we will have scandals, reputations will decline and people are going to be left with a bad taste in their mouths,” Mr. Jensen said in an interview last week. “The whole sector will decline.”

Mr. Jensen was elaborating on the trenchant comments he made last month in a forum on private equity convened by the Academy of Management. There, he excoriated private equity titans who sell stock in their companies to the public — a non sequitur in both language and economics, he said — and warned that industry “innovations,” like deal fees that encourage private equity managers to overpay for companies, will destroy value at these firms, not create it.

He also said that private equity managers who sell overvalued company shares to the public, whether in their own entities or in businesses they have bought and are repeddling, are breaching their duties to those buying the stocks.

“The owners who are selling the equity are in effect giving their word to the market that the equity is really worth what it is being priced at,” he said. “But the attitude on Wall Street is that there is no responsibility to the buyers of the equity on the part of the managers who are doing the selling. And that’s a recipe for nonworkability and value destruction.”

Ironically, the same business section of the New York Times also ran a parallel article titled, "Hedge Funds and Private Equity Alter Career Calculus". It's headline: today's hedge fund gurus and analysts are now eschewing business school educations in favor of making money instead. So investors in those funds can go to sleep at night knowing that the teachers at their local middle school, most of whom have masters degrees, may have more formal education than the people who are managing their investments.

A final sobering thought: none of today's 30-year-old hedge fund managers who have no time for business school have ever experienced a significant bear market (2001 would be the closest approximation, and that was relatively mild), to say nothing of a true market crash like that in 1987. These people have decided that the school of hard knocks is a better teacher. It will certainly be a wake-up call when they learn that failing the test in that school will cost them more than a bad grade, but in fact their futures and their livelihoods. And those that entrusted such untested executives with their money will pay the real price.