'Smart Investors' Don't Seem To Be Investing

by: John M. Mason

Some of the smartest investors, private equity funds, don't seem to be very anxious to invest. The state of the economy and the uncertainty surrounding regulations and governmental policy seem to be just some of the things that are keeping these, and other "smart" investors from investing. Maybe other investors should pay attention to what these "smart investors" are doing.

It seems like private equity firms are sitting with about $1.0 trillion on their balance sheets and are faced with the problem that they need to invest the money in the next twelve months or so…or must give it back to their investors. Andrew Ross Sorkin writes in the New York Times: "It is a $1 trillion game: Use It or Lose It."

What's going on?

Well, the economy is growing, but, barely. The Federal Reserve System has entered into another round of quantitative easing, but there is a lot of skepticism about its effectiveness in raising economic growth. There is still work to be done by politicians to avoid the "fiscal cliff." And, there are still many uncertainties pertaining to how all the financial regulation is going to work out, how the eurozone is going to deal with its problems, and how deleveraging is going to continue to depress business and consumer spending.

And, this seems to be why very little is going on!

The problem is the same as the one I wrote about just the other day. Corporations have built up big "war chests" of money to engage in mergers and acquisitions. And, because of the environment they are just sitting on the "powder." Mergers and acquisitions are just not taking place at the pace we once thought they would.

Hedge funds also face a similar problem of excess cash on hand.

Private equity has all this "dry powder" but what does it do with it? Can private equity expect the economy to improve much over the next twelve months? Can deals get better over the next twelve months?

Not real encouraging, to say the least.

So what to do?

Sorkin writes that "it is possible we could see a series of bad deals with even worse returns."

Why? Well, there seems to only be two choices.

First, too much capital could chase too few deals over the next twelve months.

Already, the evidence points to rising multiples of EBITDA. This year the multiples are around 10.6, up from 10.3 in 2011. Historically, "many of the most successful deals in the private equity industry were bought for six to eight times EBITDA."

Some relief may exist for deals at this price in the fact that private equity firms can borrow at such low rates of interest. However, this remains to be seen.

The point being that there appears to be a lot of capital around and, given the state of the economy, there are not a lot of sweet deals sitting out there to be gobbled up. An environment like this is never the kind of environment that will produce exceptional returns.

And, many of these funds are now publicly owned. Shareholders have to be considered in the possible outcomes.

The second point is that private equity firms could take on riskier deals. This, of course, could produce some real winners, but, over all, the industry is likely to suffer at this time if it takes on more marginal deals.

The private equity funds could just return the money. Several hedge funds have done this over the past six months.

The problem with this, as Sorkin points out, is that if the private equity funds do not spend the money they have already raised, they will probably find it will not be easy to raise more money in the future.

So, what are the private equity funds to do? Like these other areas I have just mentioned, we need to closely observe what these investors do over the coming months.

Private equity money is supposed to be "smart money." Henry Kravis, Stephen Schwarzman and David Rubenstein, all are looked upon as very astute financial players. Same with people in the hedge fund area. And, this holds true for many corporate enterprises.

Doesn't it tell us something when this "smart money" is sitting on the sidelines. Doesn't it tell us something when the "smart money" is facing the dilemma of using the cash they have resting on their balance sheets…or losing it.

Personally, I think the example being set by some of these financial leaders is the correct decision for these times. Some hedge funds have given investors their money back when they feel they have more money on hand than they can successfully invest at this time. Some corporations, who don't have to give their cash hoards back, continue to just sit on the money.

My own experience: one of the banks I helped to turnaround was a bank that had gone public and raised a substantial amount of money. Raising all this money "proved" to board and the management that they were financial geniuses. So, what did they do with these funds? They got into things they had no business being in, they paid too much for assets, and they lost most of the capital they raised. Money just lying around when you don't need it can be a dangerous temptation to do something dumb!

The economic climate is not a good one. There is too much re-thinking and re-structuring that needs to be done. Because of this there is too much uncertainty about the future. The "smart money" seems to be realizing this and pulling back from committing funds just because it has money.

This doesn't help the economy to grow, but it is foolish to toss money into the pot if there is very little chance that doing so will help the economy grow faster.

This is not a good environment to invest in. But, maybe we, other investors, need to listen to what the "smart money" is doing.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.