A Lot of Hot Air

The business press has uncovered yet another potentially catastrophic economic trend. This time it’s private equity firms, which are flush with money and making a lot of big investments - -an apparent sign of trouble. Emily Thornton of BusinessWeek sounded the alarm last week, telling us that “perils lurk in the shadows of private finance.” Then the Sunday New York Times hit us with “The Great Buyout Bubble,” a story warning that the “advent of supersized [private equity] deals…lurks below the surface.”

Our first reaction to this was to dive under our desks lest some gigantic deal burst forth from the depths and splatter us with ectoplasmic goo.

But then we thought about it. Can big deals lurk? No. Are they spooky, scary, or icky? Not really.

Thornton commits the frequent journalistic sin of attempting to weave a frightening trend out of a single thread of news — in this case, the recent collapse of investment brokerage Refco Inc. Refco happened to be partly owned by a private equity fund; therefore, Thornton writes, it serves as a “wake-up call about the potentially dangerous flood of money surging into private equity firms and hedge funds.”

Really? Refco went to pot for one reason: Its CEO was a crook who got caught hiding $430 million in debt. If a private equity investor hadn’t put its money into the company, some other entity would have. The CEO’s scheme did involve shifting debt to a New Jersey hedge fund. But for us to believe that Refco spells doom or danger for the private equity and hedge fund industries as a whole, Thornton would have to demonstrate that these funds will lose value because they are regularly partnering with crooked companies.

Thronton doesn’t do that. Instead, she begins by informing us that we ought to fear the “dangerous flood” of money because … well, there’s “too much money.” And, apparently, “some experts” believe the money “will lead to further hedge fund blowups — and possibly future Refcos.” Is there evidence to support this provocative theory? Thornton gives us a single quote, from a professor who says, “last time you had so much capital sloshing around … a lot of deals were done with marginal companies.”

The professor is right. A certain percentage of capital always ends up in companies that aren’t very good at what they do. But the question is, is this now happening to the extent that private equity investors are in “peril”? And how in the world does investing in dud companies lead to a wave of “hedge fund blowups” caused by scam artists?

We are left wondering.

But “cash-bloated” funds are not the only problem. Thornton explains that, “major investment banks and auditors are giving stamps of approval to initial public offerings that emerge from the murky private-investment world.” That sounds pretty scary — except that every IPO emerges from the “murky private investment world.” If a company were already public, it wouldn’t have an initial public offering.

Thornton goes on to suggest that investment banks turn a blind eye to fraud when they handle these IPOs. Does she have evidence for this? Sure she does: Refco. “Credit Suisse First Boston, Goldman Sachs, and Bank of America may have been ignorant of [Refco’s] alleged fraud,” Thornton writes. “But they moved ahead with the IPO even though there were substantial deficiencies …”

To say that the banks “may” have been ignorant is to suggest that it is equally possible that they “may not” have been. That is a very bold — and appalling — suggestion given that nobody (aside from BusinessWeek) has charged the investment banks with abetting a fraud. Even if they are someday found to have ignored “deficiencies,” one case does not make for a worrying trend. To the contrary, just about every case of corporate malfeasance in recent years has involved public companies of long standing, not private companies selling shares to the public for the first time.

As further evidence that buyout firms’ IPOs are “risky,” Thornton offers only the wisdom that these companies have generated returns that “range from 100 percent to complete wipeouts.” We’d like to offer a benchmark that would give those numbers some meaning, but as far as we know, returns on every investment since the invention of money have begun at zero.

Nonetheless, we are assured by Thornton that investors are becoming increasingly skeptical of these IPOs. She quotes one of them who says, “no way you can rely on an auditor … for a guarantee of no chicanery.” We’re guessing that this investor was less skeptical about new IPOs then simply exasperated at having to teach Business 101 to a reporter. Every auditor opinion carries a disclaimer noting that the auditor doesn’t examine everything and shouldn’t be relied upon to discover scams. Every businessperson knows this. For BusinessWeek to portray it as news is ridiculous.

And so is Thornton’s attempt to scare us with a recycled story.

Hoping for something more substantive, we turned to Sorkin’s article in the New York Times. The piece includes the obligatory reference to Refco, but it focuses more on the idea that the private equity industry has too much money.

Unlike Thornton, Sorkin at least attempts to explain the problem. His basic point is that a lot of capital has been flowing into private equity and this could cause investors to pay more for the companies they invest in, which generally makes it harder to reap good returns from those investments. In some cases, to compensate for the higher prices, investors taken more debt to enhance the equity returns, which adds to the risk.

This is all true. But should we worry about a “Great Global Buyout Bubble”? As with all “bubble” stories, Mr. Sorkin’s report overstates the point. There are always cycles in business; valuations don’t go up forever or go down forever. To say that something that is “up” today will go “down” someday isn’t very insightful or interesting.

In any case, a lot of sophisticated investors are still betting that many funds will continue to do better than the stock market. That’s why they keep giving their money to private equity firms. If Mr. Sorkin knows something they don’t, he isn’t telling us. In fact, he concludes his story by saying that the smart investors will do fine (of course, he can’t resist describing them as “lucky”), but the hot money probably will not.

That’s not very scary. And it’s not news.

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Mark R. Mitchell wrote the The Audit column in 2006.