PureVC

It's been a tough year for private equity

It's been a while since the Madoff news broke and it does sadden me to hear the news how a single person pulled off the largest Ponzi scheme known to mankind. I am tempted to say once again that it is all about trust - a money manager must trust his partners and partners must trust their money manager. However, the Madoff scheme appeared to have all the makings of lots of relationships built on solid trust. Perhaps too much trust.

Most of the investors that had money with Madoff had a personal connection to Mr. Madoff or someone who had this connection to allow access. Additionally, statements were produced backing up transactions and asset values. And people who wanted to get their money out were able to because there were so many other investors coming in. It is easy in hindsight to say that any vigilant investor should have seen the signs. However, all of these factors enabled the kind of trust that only a money manager could dream of - blind trust from investors.

Part of me is very distraught over Madoff because it paints a bad picture of the hedge fund industry. A picture of dishonesty and scandal. Another part of me is not distraught because the people that lost money with Madoff were either of the wealth that they can afford to lose money or they were stupid enough to put 100% of their net worth with a person that they did not know very well. With any financial investment there is risk and an investor must be willing to lose his entire investment. There was greed involved and this greed came in the form of investors willing to do anything for returns including trusting someone that they did not know well.

The silver lining to the Madoff scandal is that where there is carnage there is opportunity. When it is harder to start a hedge fund that means it is a better time to start one and to be in the business. There is less competition and only the very strong survive. These past few years have been a trying one for almost all of private equity - buyout funds getting bad press, venture capitalists with few exit opportunities, real estate values decreasing with tight credit, and hedge funds facing massive redemptions and loss of trust from investors.

But all things come in a cycle. These are the times when managers must dig deep and lean in and set things up for the next wave to come. And there is no doubt that another wave is coming - it may take a while. But, the economic policies being set forth to get us out of trouble will undoubtedly stoke a huge blaze in the other direction. Money flows to the best returns and right now the government is decreasing the rates of return on everything and driving money toward real estate and equity.

The recapitalization has taken place in the economy and the Madoff scandal just triggered the reset button for the hedge fund industry.

Deleveraging, Recapitalizations, & Margin Calls

People still don't seem to believe or comprehend the depths and extent of the financial crisis. Here is my brief explanation. We have been in an economy built on leverage and that leverage is coming down like a house of cards. Banks and financial companies were levered 40:1 loaning monies out that far exceeded the capacity for defaults. It started with residential mortgages and sent the financial world reeling as banks packaged these loans and sold them to others. Due to recent changes in accounting rules, banks were forced to value these assets "marked to market". Thus when the market froze and there was no liquidity to trade debt, valuations declined. We saw the collapse of some venerable investment banks such as Bear Stearns and Lehman Brothers as well as thrifts such as Washington Mutual and Indy Mac and mortgage titans Freddie Mac & Fannie Mae and Countrywide - the list goes on and on. We also saw the swallowing of Merrill Lynch and Wachovia, and the near crumbling of Citigroup. Even Goldman Sachs and Morgan Stanley have not been spared.

For those of you who believe that the financial companies will be coming back anytime soon, please think again. The market no longer values any business model that relies on leverage. In order to deleverage, companies must sell assets both good and bad. This compounds the problem as these assets are worth less and less. To make matters worse, the entire industry is in trouble and there are no buyers to take on leverage (the only buyer is the Federal Government). Anybody that acquires or merges with another insitution is simply asking for trouble. How can an overleveraged bank imagine that it can purchase another weaker overleveraged bank without weakening its position? It can't. Thus, it must go back and raise funds such as Bank of America did after its Merrill acquisition. Dividends will be cut completely. Massive amounts of equity will need to be raised. And when the federal money runs out we will be in trouble.

Thus the economy is in a massive recession and is shrinking because of deleveraging. If we were levered 40:1 and we are going back to 10:1 leverage then you can imagine our economy will shrink that same amount. If you don't understand what I am talking about, think about the size of the economy as measured by credit card transactions. Imagine if your bank suddenly froze your credit cards and you could not buy anything on credit and you had to use cash. Transactional volume would come to a halt because most people use credit to pay for just about everything. Unfortunately, a freezing and cutting of credit extended to consumers may actually happen. You can imagine what this will do to retailers. It looks like we are going back to the age where cold cash is king.

Essentially, we have had a recapitalization of the entire economy. The stock market has lost trillions of dollars as reflected by the haircuts of stock prices. Open up your 401k statement and you will see what I am talking about. 99% of the population does not understand what "recapitalization" means. In the private equity world, recapitalizations are the re-valuing and re-valuation of a company's worth. When you hear "recap" it typically refers to loss of valuation to the downside - think "massive shrinkage of company's value". Sometimes a recap is to the upside but that is what we would call a "dividend recap" meaning that we are taking out money from the company at the time of recapitalization. Anyways, the key theme in a recap is this - previous investors typically get washed out unless they "pay to play."

One final thought - the entire world has been put on a "margin call". How? Well, the market has told us that any business model using leverage is no longer desirable. Thus anybody with leverage is forced to close out its leverage down to either zero or something more reasonable. This is why it is a treacherous downward spiral - the only assets to sell are those that are devalued and those companies that are publicly traded are thus in a bad position. They have margin calls on them and must sell devalued assets that are losing more value everyday.

Do you still think that the next shoe to drop is not the commercial real estate industry? Or the consumer credit industry? The market thinks leverage is evil - any business models with leverage must adapt or become the next victim of market evoluion.