When smart money does dumb things â€¦

During the housing bubble, a lot of lenders lost their minds. It was as if some mass psychosis took over even the experienced executives, convincing them to do exceedingly dumb things.

They didn’t bother checking borrowers’ incomes or assets â€¦

They didn’t care if the loan covered the entire value of the house â€¦

And they weren’t the least bit concerned that all kinds of exotic mortgages were being doled out to people with horrible credit histories.

It was pure insanity! And predictably, all that dumb lending is now resulting in defaults, delinquencies, loan losses and foreclosures.

Perhaps the most amazing part is that this happened so soon after the Nasdaq boom and bust. You’d think that after losing hundreds of billions of dollars on dud dotcoms, both investors and lenders would have learned something.

But as soon as the Federal Reserve dangled essentially “free” money in front of their eyes, they morphed into greyhounds at the track. They started chasing Rusty the fake rabbit of housing riches â€¦ fundamentals be damned.

And you know what? Even though the housing industry mess is still unraveling, there’s already a NEW mania breaking out. I’m talking about the â€¦

Private Equity Pandemonium
Hitting Wall Street!

If you read the Wall Street Journal, or even pay passing attention to what they’re saying on CNBC, then you’ve probably seen at least one mega-merger headline.

TXU, a Texas utility, is close to selling itself for $45 billion. Credit card payment processor First Data may go for $25.6 billion. The largest office Real Estate Investment Trust, Equity Office Properties, sold for $39 billion several weeks ago.

It’s been a veritable feeding frenzy. Who’s buying? Private equity firms, partnerships that raise tens of billions of dollars from investors, which then turn around and use that money to fund leveraged buyouts (LBOs).

LBOs are a type of corporate takeover where the buyer funds part of the acquisition with its own funds, but borrows a much larger chunk of money to pay the rest. The ultimate goal: Take the company private for a period of time, improve its operations, then sell it back to the public through an intitial public offering (IPO).

If all goes well, the buyout firm makes a killing by selling the company for a much higher price than it paid. The Wall Street big-wigs that advise throughout the process rake in big fees. And the lenders who help the company finance the various transactions earn hefty interest payments.

How big a business has this become?

Buyout fund managers announced a whopping $188 billion in acquisitions in the first quarter of 2007.
The London-based research firm Private Equity Intelligence said private equity firms could raise $500 billion this year, up from $432 billion in 2006.
Loans for leveraged buyouts skyrocketed 65% last year to $1.4 trillion.

Everyone is hungry for a piece of the action. Hedge funds, pension funds, and private endowments are all throwing money at buyout fund managers. Big players like Blackstone Group LP and Kohlberg Kravis Roberts & Co. are raising $20 billion at a time for new buyout funds. And Wall Street firms like Goldman Sachs are opening up their own in-house funds to grab a share of the booty.

Here Are Three Signs of a
Private Equity Bubble â€¦

Right now, everyone is making money and everyone is happy. But I think we’re rapidly crossing the threshold from bull market to mania. Here are the signs:

First, market watchers are starting to talk about the possibility of $100-billion buyouts.

I don’t know about you, but predictions like this remind me of late 1999 when tech analysts were coming up with $1,000 price targets on stocks like Qualcomm.

Second, major greed is creeping into the process, and along with it, huge amounts of risk.

LBO firms paid a record high $12.2 billion in fees to Wall Street investment banks last year. That’s massive! But the banks want even more.

They aren’t just content to collect money from advising on buyout transactions anymore. They’re lending money to finance those transactions and even investing in the deals themselves. If a deal sours, they stand to lose bigtime.

Third, the very reason for making these deals has gotten corrupted. I consider this to be the biggest problem of all â€¦

Historically, LBOs were used to take struggling companies private. The idea: Get them out of the public spotlight, fire incompetent managers, slash costs, and then return the new and improved firms to the public market.

But these days, private equity buyers are throwing money at companies of all shapes and sizes simply because they have too much money to invest. This excerpt from an April 2 Bloomberg story says it all:

It’s never been easier to sell bonds for LBOs, said Eric Misenheimer, who manages $500 million of high-yield securities at J&W Seligman & Co. in New York. Hedge funds, under pressure to find above-market returns, are willing to take on the risk, so banks are packaging leveraged loans into debt securities and selling them off, freeing up capital to finance new buyouts.

Demand for high-interest debt, a key component in LBOs, is ‘voracious,’ Misenheimer said. It’s pretty much all-you-can-eat hunger in terms of the deals out there. Global rates are low and global demand is up more than ever.

Misenheimer is hardly alone. General Electric Chief Executive Officer Jeffrey Immelt told the Financial Times that he looks at about 30 deals a year. His verdict: “The vast majority only add value through financial rather than operational improvements.”

In other words, the deep thought process involved is: “Well, we have some money lying around and we need to make some fees, so let’s go buy something.”

This whole thing looks a lot like the venture capital boom of the late 1990s. Back then, big-name Silicon Valley firms like Kleiner, Perkins, Caufield & Byers were the starts of the investment world. Investors flooded those firms with tens of billions of dollars. That money went into a bunch of junky dotcom companies.

Those companies came public and insiders made millions. But the individual investors who bought those IPOs? They ended up with a bunch of worthless shares!

Do I Hear the Private Equity
Death Knell Ringing?

I’ve been listening for the proverbial “bell” to ring â€” the one that signals the top is in for the private equity pandemonium. And I think I might have heard it â€¦

Remember that company Blackstone Group I mentioned earlier? It’s one of the most prolific private equity companies active in the market today. It has spent a whopping $160 billion over the past two decades taking companies private.

Now â€¦ drum roll please â€¦ Blackstone itself plans to go public via a $4 billion IPO. Another mega-buyout firm â€” Apollo Management â€” is reportedly weighing a public offering of its own.

Look, these guys advocate taking companies private. They say it allows the companies to trim fat and operate more efficiently. So why are they going to take their own companies public? It’s like Greenpeace opening an oil refinery!

Maybe I’m reading too much into all of this. Maybe the private equity boom is the best thing to happen to us since sliced bread. But I don’t think so. I think this is just the latest investment fad fueled by too much easy money and too much dumb lending.

My take: When private equity firms start going public, that’s a clear sign that the guys at the top of the food chain are ready to cash out. And that tells me the boom is probably on its last leg.

Until next time,

Mike

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