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Peter Atwater: Why Investors Should Run, Not Walk Away From the Retail Opportunity in Private Equity


Retail investors might be better off investing in bankruptcy law firms and corporate restructuring companies. Here's why.

As a socionomist, I don't believe in coincidence. Simultaneous events, particularly in the media, are great indicators of how we feel. Like identical tiles, they form the real color of our social-mood mosaic.

This past weekend, the Wall Street Journal reported that several private equity firms will be opening up their funds to retail investors. For example, per the Journal, "Last year, Carlyle opened its buyout funds to investors who put up just $50,000, far below the $5 million to $20 million threshold it typically requires."

Meanwhile over at Barron's, the CEO Spotlight column profiled Henry Kravis and George Roberts of private equity firm KKR (NYSE:KKR).  After reading the Wall Street Journal article I just referenced, this throwaway line in the Barron's article caught my eye: "In his heavily guarded, contemporary-art-filled office in midtown Manhattan, Kravis displays a small, framed photo of New York's Joe & Rose steakhouse in 1976."

While the article goes on to describe the significance of the photo, I couldn't quite shake the image of "heavily guarded, contemporary-art-filled offices" with panoramic views of Central Park high atop 9 West 57th St., describe by a 2010 Wall Street Journal article as "one of the world's most prestigious business addresses."

To be clear upfront, I am never a fan of retail investors getting into what has historically been an institutional business.  As I wrote in Moods and Markets, tops are regularly marked by the entrance of novice and naïve investors.  Retail is always the last to the party.  After everyone else has made lots of money, mom and dad want to make some as well.  Not surprisingly, Wall Street is only too happy to help them, too.  You would think that after coming last to the party, and being burned over and over, retail investors would learn. But they don't. This time is always different.

Taken together, the Wall Street Journal and Barron's articles have me wondering, though, whether the top that is forming in private equity may be the top for the industry -- the end of a near-40-year cycle of success.

At its core, private equity is about buying a company for x and selling it for 2x.  While different firms will speak about their turnaround capabilities, their ability to create operating efficiencies, their influential political and business connections, and/or their keen understanding of a specific industry, at their core, private equity firms are speculators.  They are buying a company with the strong belief that they can sell it to someone else for a higher price later on.

While I doubt many private equity managers would ever put it this way, their success depends critically on their ability to think socionomically.   They need to buy when confidence is low and sell when confidence is much -- if not much, much -- higher.

But please appreciate what rising confidence means from a pure corporate finance perspective.  Rising confidence leads to higher P/E multiples, lower debt costs, and perceived higher debt capacity.  Just take a glimpse at this chart from this morning's Wall Street Journal on LBO debt and you'll see how true that last point is.

Talk about a near-perfect correlation to investor confidence.

But the confidence-driven benefits don't stop there.  From an operating perspective, higher confidence may also mean higher sales, lower input costs, and greater pricing power.

As you can appreciate, taken together, rising confidence creates an incredible virtuous cycle in which rising profitability is valued at higher and higher multiples by the market.

In looking at this long-term chart of Shiller P/E values, I can't think of a better time to have been a private equity firm than the past 40 years.   

While today's valuations are not back to their record 1999 level nor their 2007 highs, they are higher today than at any other time outside of the late 1920s.  They are also almost five times what P/E multiples were when KKR and other private equity pioneers started in the late 1970s. 

But rising relative valuations haven't been the only tailwind for private equity firms -- so, too, have falling interest rates.  

The steady decline in interest rates from their peak in 1981 has enabled private equity firms to not just repeatedly refinance existing holdings at lower and lower cost, but they have enabled the same firms to sell to buyers whose cost of funds have dropped as well.  Just as we saw in the housing market with lower and lower mortgage rates, falling corporate interest rates have allowed the next buyer to pay more for the same property while maintaining the same overall annual debt expense.

But appreciate that it hasn't been just lower absolute interest rates that have boosted private equity firms' success; falling relative debt costs have helped too. Just look at this chart of high-yield spreads from the Wall Street Journal on Tuesday.

Taken together and with the chart of LBO debt issuance above, it suggests that today there is almost insatiable investor demand for low quality debt at record low spreads.  Yet again, as Bob Prechter points out, as is always the case with investments, we have peak demand at the highest price.

Looking at the private equity space today, it looks like a near-perfect state of nirvana -- extreme equity valuations coupled with record low absolute and relative debt costs.  Everything that could go right for private equity firms at this point has.

Thanks to the financial consequences of all of these coincidental events, we are reaching the peak in the virtuous cycle of private equity rising confidence, and to me, the entrance of retail investors is the perfect "ring of the bell" at the top.  Mom and dad are looking at the financial consequences of the factors I have just described and they think they see opportunity ahead.  In fact, they should be worried about the risks that  will accompany an unwinding of the cycle.

They aren't the only ones, though, who should be worried.  Bond holders and bank lenders should be concerned, too.  Today, both of these groups view corporate debt as near-sovereign-like in its risk profile.  They are extrapolating the decline in corporate loan loss levels over the past 40 years to the next 40 years.

What they -- and I'd offer, the banking regulators -- are missing is that corporate loan losses have been significantly mitigated by the ability of companies to refinance their debt loads over the past 40 years at lower and lower rates.  Falling interest rates have saved company after company from default.  So too -- and this is not unrelated -- has the extreme liquidity of the public equity markets.

If the confidence cycle begins to unwind as the entrance of retail into the private equity market now suggests, investor appetite for corporate debt and equity will decline concurrently.

Not to be flip, but rather than investing in private equity firms, retail investors might be much better off investing in bankruptcy law firms and corporate restructuring companies.

To be clear, I don't wish malice on any of the participants, but few today seem to appreciate the enormity of the top that now looms -- particularly as there is very limited room for central banks to soften the blow.  With the 10-year US Treasury already at 2.5%, there is not much the Fed can do to lower interest rates.  Even more, looking at the high yield bond market, it looks like we are already experiencing peak demand.  Investors routinely forget that after major peaks, falling prices bring less -- not more -- investor interest.

As I offered above, at the peak in confidence, naïve and novice investors enter the market.  That retail investors now want to buy from private equity firms in their "heavily guarded, contemporary-art-filled offices" atop "one of the world's most prestigious business addresses" suggests that more than just your run-of-the-mill turndown in confidence is ahead.
Peter Atwater's groundbreaking book "Moods and Markets" is now available on Amazon and Barnes & Noble.
"Peter Atwater brilliantly provides a framework for understanding both the socioeconomic hubris that led to the great credit bubble of the past decade and the dark social-psychological hangover that has resulted from its collapse. In so doing, he offers an invaluable guide to what promises to be a very difficult and turbulent period ahead as we experience what he calls the 'me, here, and now' behavioral tendencies of the post-crash world."  -Sherle R. Schwenninger, Director, Economic Growth Program, New America Foundation

Twitter: @Peter_Atwater
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