First Principles September 2007

Cashing Out

Is private equity just another bubble, or a sign of sickness in America’s public stock markets?
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The private-equity business isn’t new, but the attention it’s lately been getting sure is. Carlyle, Blackstone, and some of the industry’s other leading firms have been around for more than 20 years. For most of this time, doing whatever it is they do, these companies conducted themselves with painstaking discretion and, so far as public opinion was concerned, operated invisibly. No longer. In the past year or two, the public has realized that private equity’s footprint on American business and finance is huge. People have also noticed—partly because the industry’s leaders have been foolish enough to show them—just how much money some of its executives are making.

Also see:

"Private Equity Deconstructed"
Atlantic senior editor Clive Crook weighs in on the private-equity business—why it's booming, where it's headed, and what it means for American capitalism.

For reasons I will come to in a moment, no one can be sure whether private equity is going to soar even higher or fall to earth. If it does the former, this means that something has gone wrong with America’s model of corporate capitalism. But if it does the latter, the history of its downfall will partly write itself: Two events in 2007 will irresistibly be seen as moments when the wings began smoldering.

The first was a birthday party. Stephen Schwarzman, co-founder of Blackstone, celebrated turning 60 in February with a Manhattan bash of arresting opulence. A giant portrait of the host, which ordinarily hangs (it was explained) in his living room, formed the centerpiece. The press reported the event in drooling detail. If Schwarzman’s purpose was to draw attention to his wealth, it worked. Politicians, financial regulators, and the Internal Revenue Service all surely took note. When people joked that it was the most expensive party in history, they weren’t thinking of the catering.

The other event was Blackstone’s initial public offering, in June. Schwarz­man had decided that this was a good time to cash out some of his gains. That was telling in itself, of course, since the firm had hitherto emphasized the drawbacks of a public listing. Whether or not the IPO signaled a peak in valuation—or at any rate a loss of future momentum—it required disclosure. Legal documents showed that in 2006, Schwarzman was paid $400 million, that he expected to receive nearly $700 million from the IPO, and that his remaining stake in the firm would be worth more than $7 billion.

How have Blackstone and the others created such wealth? Private equity is an elastic term, but the typical buyout transaction involves scooping up an undervalued public company, taking it into private ownership, fixing it, then a few years later selling it at a profit. Private-equity firms, unlike hedge funds, are hands-on owners of the assets they acquire. In many cases they bring superior expertise, and in all cases ruthless discipline. They usually bring one other thing as well: debt. The target firm is financially restructured, with less owners’ capital and more debt on its balance sheet. If the firm does well, the owners’ returns, now teetering on a smaller base of capital, are much higher than they would have been without the new leverage. If the firm does badly, the debt makes the hurt much worse, and sometimes terminal.

The business has boomed. There are thousands of private-equity firms worldwide. Blackstone, the biggest in terms of total assets under management, was just a four-person, one-room outfit with a balance sheet of $400,000 in 1985, according to the firm’s Web site. Today it manages, in all, nearly $90 billion in assets. The 50 companies in which it has a stake employ 400,000 people. The other big firms—Carlyle, TPG, Bain, KKR—also carry assets valued at tens of billions of dollars. From almost nothing in the mid-1990s, the global value of private-equity buyouts rose to $700 billion last year. That was more than twice as much as in 2005, and it accounted for about a fifth of all mergers and acquisitions worldwide. This year’s figures are on track to exceed that total.

Is it all a bubble? Many market professionals think so, but only harder economic times will reveal how much these gains represent real economic value, rather than financial illusion.

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Clive Crook is a senior editor of The Atlantic and a columnist for Bloomberg View. He was the Washington columnist for the Financial Times, and before that worked at The Economist for more than 20 years, including 11 years as deputy editor. Crook writes about the intersection of politics and economics. More

Crook writes about the intersection of politics and economics.

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