Fred Destin

I was inspired to write this post by an amusing article in Friday’s Financial Times (John Plender: Private Equity folks could do wonders with Microsoft) where he playfully builds the rationale for a buyout of Microsoft followed by the biggest dividend payment in history (the $288bn of available leverage assumed in the article being more than the current market cap) followed by a string of credit derivatives by the lending banks to hive off the risk, leaving everybody with no risk and cash-lined pockets and a leveraged and cash poor Microsoft.

Which begs a serious macro question: where does all the risk go?  You can simplify corporate risk to investors by thinking of two categories (performance and credit default). 

The Private Equity boys arbitrage away discrepancies between Enterpise Value as they see it and how much the banks are willing to lend to them, and very often make all their money back within months of investing by re-leveraging to the hilt and effectively creating a zero-premium equity option for upside.  Forget getting operations back in line, that’s so 1990’s.  The banks then use the credit markets to offload most of the principal risk to the derivatives market.

The Credit markets and in particular the CDS/CDO segment have grown fantastically in recent years.  In the olden days (as in 5 years ago) I knew where the risk went: from commercial banks to hapless insurers and re-insurers in search of high performance assets who sometimes still priced risk by looking at historical data and extrapolating that (think pricing FX risk by looking at the past performance of the dollar…).

But investment banks, having worked on securitising most of the assets of the balance sheets of commercial banks, have long been working on helping the hapless guys take risk off their balance sheet too, migrating it back into the credit markets.  So in this game of musical chairs … who ends up with nowhere to sit ?

In Venture Land (that’s where I reside) we do take principal risk, usually unlevered, and get funded by family offices or pension funds who take very long-term views.  Although I remember with a smile being approached by the Enron credit traders in London in the heydays: these guys were selling equity default protection on early stage venture investments and looking to securitise that too… wow … but I digress.  Remember Enron ?

I think two factors are probably at work:

• to protect the profitabilty of their net trades, the commercial banks are probably keeping the most toxic portion of the credit risk on their balance sheet when they seek credit protection (which after all the investment banks are selling to them, and these guys ain’t dummies). So I would bet that a lot of innocuous credit lines that sit on bank balance sheet are in fact highly leveraged pieces of nuclear credit exposure that the financial services regulators cannot adequately assess (meaning the capital reserved against these by the banks is probably inadequate)
• a number of the “long” CDO’s must have been lodged with hedge funds on the one hand and people with too much cash on the other (think People’s Republic of China)

… all this would suggest that the serpent might be biting its tail and that the leverage market supporting private equity returns has feet of clay. In the meantime investment banks make a fee on every leg of these transactions and the more agressive private equity shops keep siphoning the cash off their investee’s balance sheets. Not a bad day’s work if you are into making serious money. But the LTCM story proves that systemic risk (at that time starting with Danish mortages if memory serves me well) can quickly spread to an entire market. I will stick to venture and making money over 5 years, it’s more sustainable.

technorati tags:privateequity, creditderivatives, johnplender, financialtimes