Interviews September 2007

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.

Last February, private equity baron and Blackstone co-founder Stephen Schwarzman marked his 60th birthday with a celebration fit for a king. Hosted at the Park Avenue Armory, a massive fortress-like building on Manhattan’s Upper East Side, the party drew Wall Street titans, media stars, politicians, and Hollywood celebrities. In rooms redecorated to resemble Schwarzman’s own $40 million Park Avenue apartment, 500 of Schwarzman’s closest friends enjoyed free-flowing wine, a massive gourmet menu, and a private performance by pop star Rod Stewart. A giant portrait of the birthday boy (borrowed from Schwarzman’s home) formed the centerpiece of the room, reminding partygoers of the honoree.

Schwarzman’s name is not typically spoken in the same breath as, say, Bill Gate’s or Michael Bloomberg’s. His wealth does not even register among Forbes 50 richest people in America. (In 2006, he ranked 73rd out of 400, all of whom had assets of at least $1 billion.) But his wealth and professional success (along with his willingness to flaunt both) has attracted the attention of everyone from gossip columnists at the New York Post’s Page Six to lawmakers on Capitol Hill. Suddenly, an industry that has historically conducted its business quietly and discretely has many wondering: What exactly is private equity and where is all this money coming from?

As Clive Crook points out in the September issue of The Atlantic, the private equity business isn’t new: firms like Blackstone, Carlyle, and TPG have been around for decades. The term private equity refers to a range of financial activities—including hedge funds, venture capital, leveraged buy-outs—related to investments made in privately owned companies (those that have not listed their stock on a public exchange). Blackstone, like many other private equity firms, has made much of its money in the buyout business—acquiring undervalued public companies using borrowed money, taking them private, improving them, and reselling them at a profit. In recent years, helped by strong stock prices and low interest rates, this type of business has boomed, allowing firms and firm executives to rake in huge profits.

“Is it all a bubble?” Crook asks. How much of these gains reflect real economic value? Is the relative strength of the stock market acting as a temporary crutch for an otherwise unstable industry? If the bond market continues to cool as it’s been doing in recent months and long-term interest rates continue to climb, could this market crash? And above all, Crook wonders, does the flourishing state of the private market imply that American capitalism has lost its effectiveness?

A deeper and more important question about private equity is this: Supposing even some of the gains in value achieved by these leveraged buyouts are real—and that seems likely—then what is wrong with the public capital markets? Why does a firm need to be taken private to be better managed or more intelligently financed? You could see the success of private equity as an indictment of American capitalism. If Wall Street were working as it’s supposed to, you might argue, private equity would have found no space to overrun in the first place.

Clive Crook, formerly deputy editor of The Economist, is now a senior editor for The Atlantic, a columnist for National Journal, and chief Washington commentator for The Financial Times. We communicated by email on August 2.

—Abigail Cutler



You refer to the private equity phenomenon as possibly a bubble. What might cause the bubble to burst and what might such a scenario look like?

The biggest risk for the industry as a whole is probably higher interest rates. The striking feature of private-equity deals is the heavy reliance on debt to “leverage” investors’ returns—and also, since the two things go together, to raise the investors’ risks. The industry has boomed thanks partly to a global glut of risk-tolerant capital and low interest rates. Outsiders can’t say for sure what a spike in interest rates would do to the private-equity firms’ existing portfolios of assets. We’ll just have to wait and see. But even the gentle rise in interest rates that we’ve seen so far makes it harder for the private-equity firms to keep applying the same template to new projects.

Another unknown is what the collapse of a big private-equity firm might do to the rest of the industry. The firms need confident investors willing to trust them with their capital. So far, the firms have justified that confidence by earning their investors excellent returns. If that should change, and especially if a big firm goes under, taking investors’ assets with it, that eager inflow of new money might dry up across the industry.

In general, we’ve seen private equity operating under very favorable conditions. Everything has gone their way until very recently—low interest rates, lots of capital greedy for risk, a regulatory regime (Sarbanes-Oxley) that turned against public companies, and more. We won’t know what to make of the industry as it’s now run until we’ve seen it weather bad times.

Can you talk a little bit about foreign investment in these funds? When Blackstone went public back in June, China purchased a $3 billion stake in the firm. What was behind that big investment and what are its implications?

China’s investment in Blackstone was interesting. China’s central bank holds huge amounts of dollar assets—mostly U.S. Treasury bills—in its reserves. These are the counterparts of its balance of payments surplus. By buying dollars, the government holds down the value of the renminbi, which in turn helps keep China’s exports competitively priced. The problem from China’s point of view is that these assets generate very little income, and the dollar’s weakness on global currency markets makes them a poor investment. Switching a little of this money into other investments, such as Blackstone, is an effort to get a better return.

There’s an irony, though—a circular effect. The uncertainty in financial markets over China’s intentions for its foreign exchange reserves has been one of the factors pushing interest rates up this summer. China’s interest in the Blackstone IPO was a signal that its monetary policy was changing, and that something big might be about to give way in global capital markets. So it was a kind of precursor of higher interest rates; and higher interest rates are the biggest risk that Blackstone and the other big private-equity firms currently face. In some ways, China unsettled Blackstone’s business by expressing confidence in Blackstone’s business.

Last year’s attempted Dubai ports deal generated an enormous amount of controversy back here. Why is the idea of foreign countries investing in our publicly held companies such a contentious issue?

The Dubai Ports issue raised special issues, of course. People were scandalized by the idea that an Arab-owned company would be running some big American seaports—the fear was that this would compromise security. I didn’t see much merit in that view, myself. What difference does the ownership of a port make? Regardless, the port’s owners will face the same demands and standards so far as security is concerned. These requirements are imposed, and then either directly carried out or closely monitored, by the government. These are not things the company is left to work out for itself. Would a Dutch firm, or a Brazilian firm, or an American firm for that matter, require less oversight?

As for the wider issue of foreign ownership of companies in the U.S., this already happens on a vast scale—and attracts less attention, arouses less political controversy, than you might expect. Which is a good thing, in my view; long may it continue. I’m sure the country gains from a mostly open regime of inward and outward direct investment. U.S. companies own a ton of productive capacity abroad, and foreign companies own a ton in the U.S. In general, there is no economic downside to that; it’s good for everybody. I think it’s fine that the broader issue at the moment generates so little political heat.

Presented by

Abigail Cutler is an Atlantic staff editor.

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