The more you consider it, the more private equity seems the chameleon of modern capitalism. When the background changes, it changes accordingly.
Take a couple of deals from last week. Texas Pacific Group bought a 23 per cent stake in Bradford & Bingley, a small struggling UK bank. And Carlyle raised $3.4bn (£1.74bn) to buy European real estate, with plans to leverage that by more than three to one.
Both are a long way from private equity’s supposed role in the scheme of things. As a minority holder in a bank, for instance, TPG will have no more power than any other shareholder activist.
Nor is it likely to buy the whole thing. For as the head of rival Blackstone remarked last week, private equity does not want to own banks outright. That would make them bank-holding companies, and thus subject to rules that would hamper their operations elsewhere.
As for the real estate deal, Carlyle has been running such funds for a decade, with similar debt levels. But that was a boom time for commercial real estate – and when property prices are rising, big mortgages make sense. Why now?
Indeed, where is the leverage coming from? Are not banks groaning with real estate debt and deeply reluctant to take on more?
Maybe so, but Carlyle’s answer is to use consortia of smaller local banks. That rings a warning bell.
For according to Standard & Poor’s, this year loans on conventional private equity deals in Europe have been even more stretched, in terms of interest cover, than at the peak of the boom last year. The deals are smaller and fewer – but again, it is local banks doing the lending.
So now that the big banks have tired of throwing their money away, the smaller ones are getting their turn. This may be dispiriting – but not for the private equity firms themselves.
After all, there has been a wave of deals lately whereby banks with leveraged loans stuck on their books have sold them back at a discount to the private equity firms that raised them – and lending them the money to do it.
For private equity, this makes perfect sense. As the Blackstone boss said last week, past experience suggests there are excellent returns to be made from debt in the latter stages of a credit crisis.
This is a handy way to pay the bills until the credit cycle turns up again and the real business of leveraged buy-outs can be resumed.
And if the debt can be had at a discount – in businesses that the firm, as owner, knows a great deal better than the bank does – so much the better.
But none of that fully addresses the underlying puzzle. As a buyer of office buildings, loans or minority stakes in banks, private equity is working a crowded field.
Why should it be able to beat the market? And even supposing it can, what justifies the risk of leverage?
The answer is structural, and reflects the weakness of other investment models at least as much as the strengths of private equity. The key lies not in being a better buyer, but a better holder.
A veteran dealer was bemoaning to me recently the wasted opportunities he saw in the debt markets. There was so much stuff he wanted to buy – but how could he hedge it?
In private equity, the question scarcely arises. Your investors’ money is locked in for anything up to a decade.
You must report regularly to them, but, unlike hedge fund investors, they cannot pull their money out at short notice. However awful your deals may look in the short run, time is on your side.
In other words, you have no need for liquidity. In theory, neither should other investors such as pension funds.
But they do in practice, since if the managers they employ have a few bad quarters, they fire them.
In the markets that result, the liquidity premium represents free money for private equity.
As to whether that justifies the further step of leverage, we must wait and see.
But banks will always be more ready to lend to private equity than to other investors, since it will not be a forced seller of the underlying asset. And by the same token, when the loans go bad private equity has the whip hand.
We must not paint too rosy a picture. Quite a few private equity-owned
companies will go bust in the next year or two – though in some cases, all the original equity and more has been long since extracted.
But the essential point is that private equity is more smartly constructed than its rivals in the investment jungle.
It is that, rather than any fancy paradigms of management, which guarantees its survival.