PATHS OF GLORY

This month marks ten years that I've spent covering private equity. Please indulge me while I celebrate the anniversary by offering two competing scenarios for what the next decade may hold for this industry.

It is an exercise in clairvoyance that I did not undertake in 1998 when, fresh from graduate school, I joined a trade publication focused on private equity. At the time I was more concerned with figuring out what “buyouts” were, what made them“leveraged”, and why “GPs” weren't engaged in doing something more straightforward. Shortly before agreeing to the job, it occurred to me that I very possibly was about to consign myself to a dull, obscure corner ofWall Street that CNBC never even bothered mentioning.

The beat I anxiously took up instead grew into the beating heart of global capitalism. By 2005, now with PEI and finally somewhat familiar with the mechanisms and nomenclature of private equity, I still would not have predicted the astonishing growth that the next two years would bring.

So, with a haze of uncertainty enveloping the market, now what? Where will private equity be in 2018? I can draw two divergent paths for private equity that proponents of the industry will identify as “good” and “bad”, respectively.

First the good path. Equity markets around the world sink to depressing lows, leveraged finance goes away and corporations become too mired in triage to focus on growth through acquisition. GPs, seemingly the only players with capital to deploy, fan out across the world to buy companies on the cheap, albeit without the benefit of much debt.

In the meantime, the richly priced, highly leveraged deals struck in 2006 and 2007 hold steady, thanks in part to their strong positions in their markets as well as to slack or non-existent bank covenants, which allows some of the weaker investments to limp away from the jaws of bankruptcy. Crucially, private equity firms deploy serious human and other resources in helping these companies to improve and grow.

The returns from the 2006 and 2007 period are middling, but in line with lowered expectations. The returns from the 2008 and 2009 vintages, however, are epic. In the years thereafter, stock markets everywhere surge back as the global economy continues its ascent. Lashings of cheaper leverage are applied to portfolios. GPs in possession of profitable, well governed businesses begin selling them like hot cakes, and distributions pour into the coffers of veteran and new limited partners alike. This more than validates the decision by many of these institutions to initiate or upsize allocations to private equity, and the allocations continue to expand. Private equity, or whatever the consultants are calling it in 2018, is on its way to reaching percentage parity with public equity in the institutional portfolio, and is seen as a mandatory way to participate in private corporate growth around the world.

Now the bad path. It's 2008, stock markets reach a low and leverage is hard to find. Many of the deals done in the booming two prior years suffer irreversible declines in value – simply put, nobody is going to pay these GPs more for their companies than what they already ponied up in the bygone bidding frenzy. The burden of leverage on the portfolio companies prevents them from taking advantage of new opportunities for growth. GP promises of “adding operational value” prove hollow – many of these guys can barely run a two-office general partnership, let alone the underperforming, spun-out widget division of a major corporation.

In 2008 and 2009, GPs spend the rest of their equity on off-strategy, equity-heavy deals. These, too, disappoint. Years go by and distributions are few and far between. The returns assumed for private equity by institutional investment consultants do not materialise, and this causes LPs to lower their allocations, and in many cases to withdraw from the asset class. The collapse of many hedge funds and the underperformance of real estate funds colour the institutional view of “alternatives” and politicians begin demanding that pensions retreat from this sink-hole of chicanery.

Which path do I think will be most likely? I think private equity will end up in a good place, with brief and scary diversions toward the bad place. But it all hinges on GP skill. If we begin to see a wave of bankruptcies and losers in private equity portfolios, it won't be the result of bad luck, but of GPs having engaged in something they insist they don't do – irresponsible financial engineering.