Collusion By Private Equity Customers

This morning's Wall Street Journal featured a rather surprising article in the Money & Investing section.

It seems that CALPERS and other large, pension-related, asset-rich entities, all members of the Institutional Limited Partners Association (ILPA), have explicitly met to formulate a set of 'principles' which they will demand private equity funds adopt.

In response, several private equity shops are exploring a lawsuit on anti-trust bases.

The Journal piece ends with what is probably the most sensible point, which is a quote from an attorney expressing the view that the federal bench isn't going to go to bat for the likes of Henry Kravis.

While almost certainly true, it is, also, beside the point. Justice is supposed to be blind, and if the private equity groups have a case, well, then, they have a case.

But they really don't.

The ILPA may meet to draft common principles. But who said that's the entire market for private equity funding? In fact, if anything, the ILPA is probably doing themselves a favor by potentially excluding themselves from private equity deals.

After all, look at Cerberus. Great job with GMAC and Chrysler, guys. Isn't that John Snow, former Treasury Secretary, overseeing those embarrassments?

The situation here is really quite simple.

Over the past few decades, private equity groups became overwhelmed with funding. Their activity levels, and the prices of their acquisitions, soared. In time, Blackstone even went partially-public, enriching its partners at previously unheard-of levels.

If that's not a sign of an overheated market, what is? And ILPA members were very likely in the vanguard of the rush to overfund private equity groups.

Now, having become disappointed with results, these institutions are crying foul and developing "principles."

By the way, last time I looked, CALPERS had done a very fine job of screwing up on its own with a reckless land investment scheme that's gone sour at a huge cost to the entity's assets.

Here's what will actually happen in years to come.

First, the ILPA will try to hold private equity groups to the newly-restrictive terms. The vaunted "principles" center around, as you'd expect, pricing. Terms such as fees, disclosure and investor oversight.

Second, a few ailing private equity groups will cave in, to preserve funding. But the better firms won't.

Third, the better-performing private equity groups will be pursued by ILPA members who will toss away their newly-created terms in order to get a piece of the best returns in the sector.

That's how these cycles always work. Hedge funds are the same way. Once burned, institutional investors declare that they won't stand for such restrictive terms. Then, when the hedge funds become the best-performing investment firms, such concerns are easily discarded in the pursuit of returns.

There won't be a lawsuit by private equity groups. The weak ones will want it, but the stronger ones realize it serves no purpose to air this dirty laundry. And they will naturally regain the institutional customers once market conditions turn to their favor once more.

Still, it's an interesting circus to watch. Institutional investors looking to blame the recipients of their investments, rather than admit to their own mistakes, while the weaker private equity groups run for legal cover.