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The Private-Equity Time Bomb

Robert Kuttner provides a decent book review on The Buyout of America: How Private Equity Will Cause the Next Great Credit Crisis, a recent book by Josh Kosman.

This is a well-written review of a seemingly interesting book. As a practitioner, I offer my thoughts on points which require clarification.

“Private equity will cause the next great credit crisis.”

This statement is misleading, as these are not separate “crises.” Risk is being re-priced, and this repricing of risk affects all asset classes, especially highly-leveraged investment strategies. This is simply a multi-year process which affects individual asset classes in different stages. Residential homeowners typically have smaller balance sheets, and as such, they are the first to be impacted when risk becomes more expensive. The current and future pain in the private equity market is part of the same financial collapse. Compared to individual borrowers in the residential market, many portfolio companies of private equity firms have larger balance sheets, and as such, a greater ability to deny reality in the short-run.

(Note: We are not experiencing a financial crisis, but a financial collapse which contributes to an economic crisis).

“Early in the last decade, private equity thrived on the same bubble that pumped up housing prices and created the sub-prime boom and the general illusion of prosperity. And the entire game was eerily reminiscent of sub-prime.”

Many observers mistakenly use the word “subprime” to characterize the financial collapse. By calling it a “subprime crisis,” the financial collapse is seen as limited to poor people who have typically borrowed money to buy homes. Further, these people are generally viewed as irresponsible borrowers who might deserve any negative consequences.

In many ways, this phenomena is similar to the tech and telecom (TNT) collapse. Early, the TNT collapse was mislabeled a “dot com” crash, and most industry participants searched aggressively for “the next big thing.” This chase traveled down the path from business-to-consumer, business-to-business, optics, storage and wireless. Unfortunately, the industry suffered from general overcapacity, and the elimination of this overcapacity (via bankruptcy, mergers and acquisitions) provided a difficult headwind for companies of all sizes, although the first signs of weakness were in the business-to-consumer (“dot com”) segment.

“By giving financial engineers a deduction against taxes otherwise owed for the interest paid on borrowed money, the tax code creates an incentive for private--equity artists to rely heavily on borrowing.”

The 2000s were very similar to the 1980s; leverage-based (credit-based) strategies dominated in both eras, whereas equity-based strategies dominated in the 1990s. The leverage-based strategies were enabled by cheap credit, and this cheap credit allowed prices to rise to unjustifiably high levels in all asset classes.

However, the deductibility of interest is not unique to private equity. This interest deduction applies to most corporate leverage and real estate leverage. As a nation, our current tax structure effectively subsidizes debt and penalizes savings, and our indebted state (at the government, corporate and personal level) is a natural result of these incentives. When politicians begin to consider (i) eliminating the tax deductibility of interest and (ii) eliminating the tax on savings, we will begin to use less leverage and more savings in our balance sheets at every level.

“[P]rivate-equity companies are exempt because they do not have shareholders in the usual sense of the term. The companies' shares do not trade on exchanges, though they have limited partners who are akin to shareholders.”

This misses an important point, because private equity firms are subject to a much stronger system of checks-and-balances than public company management teams. First, compensation is determined on a cash-basis rather than an accounting basis, so bonuses are paid based on real profits, not imaginary accounting-based profits. Second, profits and losses are cumulative, so any premature bonuses paid today will be lowered by future losses.

Ironically, this stronger system of checks-and-balances has been created by limited partners, many of whom also invest large sums in public equity. To their detriment, these investors are wiling to tolerate much looser standards on management teams in the public markets.

“True venture capitalists, Kosman writes, "invest in growing companies, and they maintain an active oversight role as these companies grow and change."

This sounds wonderfully idealistic, but the equity-based strategies of the 1990s ended in absolute disaster. Private equity investing utilizes two main strategies: leveraged buyouts and venture capital (a/k/a growth equity). Is one strategy inherently better than the other? Probably not.

After many years, some observers are rewriting history to glorify the venture capital business which suffers from two core problems: (i) There is no effective oversight on management teams as a minority investor. There is primarily influence, and influence is generally insufficient. The leverage-based strategies usually allow control by the investor, and this provides a better system of checks-and-balances on management teams and (ii) In our country, there is very little growth. The demand-side has been sated for at least 10 years, and the supply-side remains buried in overcapacity. This latter issue receives no press attention, but it is the bigger problem. As the collapses in Japan and in the TNT sectors have demonstrated, eliminating this overcapacity is naturally deflationary.

In conclusion, this book is probably an interesting contribution to the study of private equity investing. As more of these books and articles are published, people might begin to realize that private equity investing is no longer an alternative asset strategy, and it has a very real impact on the economy.