Liquidity, Risk and Greed: Will The Private Equity Business Self-Destruct?

Monday's Wall Street Journal featured an article, positioned as "Financial Insight," on what is viewed as excessive private equity borrowing . Excessive risk is taken, passed off to banks, and greed rules. Liquidity everywhere, fueling ever more risky, leveraged deals.

Haven't we seen this before? According to Hugo Dixon, the author of the piece, heads of two leading private equity partnerships boasted recently, at the Davos Economic Forum, that they are cutting their risk exposure while increasing volumes, by requiring that the banks who wish to play must hold debt, or offer bridge financing. This begins to sound very much like Mike Milken's original LBO machine of the 1980s at Drexel Burnham. And recalls the ill-fated Ohio Mattress deal which drove First Boston into the arms of Credit Suisse after the 1989 imbroglio.

To be sure, it's likely that some private equity group will do one too many marginal deals, which will catch a large- or medium-sized bank off-guard, holding a sizable debt position, and it will either fold under the weight of the bad paper, or be driven to merge with another institution.

On one level, it's the same old, same old...every decade, it's a new financial product/market that melts down. Because, as my mentor, Gerry Weiss, taught me at Chase Manhattan Bank nearly twenty years ago, financial services firms tend to find growth most easily, in enlarging markets, by taking more risk. Especially when upfront fees are the revenue and profit source, but back-end loaded losses are the risk. The people deal, get paid fabulously, and walk, with the public or private institution owners hold the bag....er....risk......and take the losses.

When I first read Dixon's piece, I thought it pretty much does describe how the private equity craze will end. Then I read Alan Murray's piece in the Journal later in the week, and wrote this post. I now feel that several premium brand names in the private equity space- Texas Pacific, KKR, Silverlake Partners- may succeed in continuing to buy and improve the long-term value and returns of formerly-publicly-held companies without undue risk. I suspect that what Mr. Dixon envisions will occur among a second-tier group of private equity partnerships and banks dealing in more marginal "opportunities."

It might dent some of the frothier fringe deals but, like the mortgage banking market of the past year, won't adversely affect the better-positioned players doing higher-quality business.