Anyone who has been around finance a while recognizes the blowout phase. Investors are desperate to put their money to work even when prices are look precarious. Deals go from being negotiated to being sell-side dictation. Rationalizations abound. Remember the line from Chuck Prince, then CEO of Citigroup from July 2007: “When the music stops, in terms of liquidity, things will be complicated. But as long as the music is playing, you’ve got to get up and dance. We’re still dancing.” Mind you, he was so bold to make that remark right as the Bear Stearns subprime hedge funds were imploding, which kicked off the first acute phase of the credit crisis.
But what most people don’t remember about that Prince quote was that it wasn’t about mortgages. It was about lending to private equity which had also gone into a moonshot in 2006 and early 2007. And as we’ll discuss in more detail soon, private equity again has the classic signs of being in another “devil take the hindmost” phase of frenzied capital commitments.
And the reason more of Citi’s loans did not come a cropper was that the “goose asset prices” that has housing prices and consumer confidence as its main targets incidentally bailed out private equity. Even so, private equity performance post crisis has been underwhelming, with investors on a widespread basis failing to meet their private equity benchmarks. That means they have not earned enough to compensate the risks of that strategy.
Even so, we know the reason Citi escaped being nationalized as a result of its overconfidence was the heavy representation of board member Bob Rubin acolytes in the officialdom, most important Timothy Geithner as New York Fed chairman and later Treasury Secretary.
Last year, average prices paid, measured in EBITDA multiples, were at record highs, exceeding the 2007 peak. Yet while past bubbles show that crazy prices can always get crazier, there are warning signs that a peak is probably coming sooner rather than later. The Fed is clearly eager to raise rates as soon as it has any thin justification to do so. A rising rate environment will hit long-dated and higher risk assets the hardest. That means private equity is doubly exposed.
And if the Fed does not continue tighetening, that would likely be the result of deflationary forces continuing to bite, say a downdraft from China, a shock wave from Europe due to a Brexit vote going through, or other centrifugal forces on the Continent strengthening (say Merkel losing her Chancellorship, or Marine Le Pen continuing to gain in French polls). Deflation is not a friend of risky assets. The best place for investors in inflation is in cash, cash-equivalents, and safe bonds. Inflation increases the cost of debt in real terms, which again is punitive to highly leveraged transactions, since deflation also leads businesses and consumers to tighten their belts, hurting corporate revenues and/or profits. And the popularity of negative interest rate policies only makes a bad situation worse. It hurts the incomes of retirees and other savers, leading them to curtail spending. It’s destructive to bank; bank pressure is reportedly one of the big reasons the Fed is so eager to ‘normalize”. It’s also destructive to investors like pension funds and life insurers....MORE