Private Equity, the Giant Before the Bust, Hangs On

Correction appended April 2, 2009

Back when we had a functioning financial system, the guys who ran private-equity (PE) firms stood very near its pinnacle. “The new kings of capitalism,” the Economist called them. The kings of birthday parties too: the $3 million 60th-birthday bash for Blackstone Group chief Stephen Schwarzman in February 2007 will go down in history as a glaring sign that the boom was about to go bust.

But Schwarzman, unlike several Wall Street kingpins at his party, remains gainfully employed. His pay at Blackstone dropped to $350,000 in 2008 from $180 million the year before, but he’ll manage. The failure of a hedge fund run by Carlyle Group, another big private-equity firm, played a bit part in the March 2008 minipanic that brought down Bear Stearns, but Carlyle as a whole is still chugging along. Private equity may not be thriving, but it is at least still standing. (See 25 people to blame for the financial crisis.)

This is in large part because of how PE firms are structured: they lock up investors’ money for a decade and rake in 2% annual fees even when their investments tank. When they borrow money to buy a company, the debt gets stuck on the company’s books, not theirs. As a result, most have been able to effectively hold their breath through the turmoil.

They can’t hold it forever, though, and what happens next is Topic A in private-equity circles. Everybody agrees there’s a shakeout on the way; at industry conferences one hears predictions that anywhere from 20% to 50% of PE firms will go out of business. There’s less agreement about the survivors. Will they land back atop the financial heap and continue to steer a big part of the U.S. (and the global) economy? Will the top students at the top business schools still pine for PE jobs? Or was the PE boom just an artifact of a three-decade debt bubble that will be deflating for years?

First, some background: private equity refers to what in the 1980s was called the leveraged buyout (LBO). LBO artists such as Henry Kravis and Carl Icahn borrowed lots of money on the junk-bond market built by financier Michael Milken and used it to finance takeovers — sometimes hostile ones — of struggling corporations. During the recession of the early 1990s, the LBO business faltered, and many predicted its demise. But buyout funds re-emerged under the more genteel moniker private equity, eschewed hostile takeovers, reliably outperformed the S&P 500 and grew to be a far bigger force than they ever were in the 1980s. From 2005 through mid-2007, PE firms — loaded with cash from pension funds, college endowments and sovereign wealth funds, and able to borrow trillions more from banks and bond investors — went on an unprecedented buying spree, snapping up the likes of Chrysler, Dunkin’ Brands, Harrah’s, Hertz, and Hospital Corp. of America in hopes of later selling them to the public or to another company or even to another PE fund. (See pictures of the remains of Detroit.)

Now comes the hangover. Funds launched in 2005 and 2006, which invested most of their capital at the market peak, will struggle ever to turn a profit. But research firm Preqin reports that of $2.5 trillion in private-equity assets worldwide at the end of 2008, $1 trillion was “dry powder” — cash that hadn’t been invested. There are lots of cheap companies out there, and private-equity firms with cash on hand will surely hit a few home runs with investments made in the coming years.

After that, what you think of the industry’s future depends on what you think has enabled it to make so much money in the past. The optimists argue that PE firms profit by being good at governing corporations. “When you’ve got overly ambitious and hardworking people who are putting their own money at risk,” said Carlyle Group managing director David Rubenstein when I got him on the phone, “it’s an alignment of interests with management and shareholders that will always enable private equity to make money.”

But Rubenstein didn’t deny that easy credit also boosted profits. And at the Buyouts East conference in New York City in late March, I heard another industry veteran, George Siguler of the firm Siguler Guff & Co., paint a grim picture of private-equity returns in a deleveraging and struggling economy. “The available universe of companies that buyouts can buy is essentially mediocre companies, and mediocre companies are going to have a much tougher time,” he said.

What does it mean for the rest of us if he’s right? Top-of-the-class M.B.A.s would have to find other careers, and pension funds and endowments would lose some money. But there’s a silver lining: Among the greatest bargains in investing right now, Siguler said, are brand-name giants such as General Electric and Boeing. Private-equity firms can’t afford to buy them. You and I can, a share at a time.

The original version of this story contained a misspelled proper name.

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