Friday Letter: Cyclical overconfidence

The industry should take care not to become too sure of its ability to see its way through the current credit crunch.  

Just asking: how did vintage-year 1929 private equity funds do? It’s a cheeky question but highlights an important point: so many GPs are confident about how to play the current financial meltdown, but very few of them have been in business through more than a couple.

Most private equity firms were formed in the 1990s and 2000s. And yet today one hears GPs talking about the current mess as if they’d navigated anything like the current crisis ever before.

Let us review. In 2001 and 2002 we had the tech/telecom fiasco. That hit venture firms hardest and mauled the buyout firms that had strayed into dotcom territory. Before that was the emerging markets bust of 1997 to 1998. This caused LBO debt to dry up, but in reality the bad vintages of those years were due more to the subsequent recession. Before that was the recession of 1990 and 1991, during which LBO debt went the way of hair metal bands and vanished.

If in fact “we’ve seen this movie before” then there will be a happy ending for many private equity firms followed by a thrilling sequel. The best vintage years in private equity, according to figures compiled by the State Street Private Equity Index and reported in the April issue of Private Equity International, have been 1993 and 2003 – directly following recessions. The average net IRR of funds launched in 1993 is nearly 27 percent. Funds launched in the vintage year 2003 average just over 33 percent, although these numbers are being eroded now. Meaningful performance figures through previous recessions don’t exist because the population of funds tapers off into the 1980s.

Are private equity market participants – and many economic pundits – overly confident that the current meltdown will enjoy recovery characteristics similar to what has been seen in recent years? Many professional investors are openly predicting “middle of ‘09” as the turning point. Let’s hope so. Each financial mess has its own unhappy story, but the current one is incredibly broad and powerful, threatening to bring large parts of the financial world to its knees. These are the times to be sceptical of conventional wisdom, and conventional wisdom in private equity now holds that we have just one year of pain to look forward to.