Thursday, November 6, 2008

Blackstone's Woes: Some thoughts on Private Equity

About a year and a half ago, at the height of private equity's success, I put together a presentation on LBOs that examined what makes an LBO work and, conversely, why many of them were destined to fail. The LBO I looked at was the Harman deal, backed by two big names - Goldman and KKR. Based on my analysis then, I concluded that Harman fit none of the requirements for a good target - it did not have significant debt capacity (nullifying the leverage benefit), it was well managed (eliminating the restructuring need) and did not suffer any serious separation between management and ownership (countering the going private argument). If you are interested, I have a paper describing the deal that can be downloaded by going to: 
My purpose in the paper was not to pick on Goldman and KKR but to make the following points:
1. Even smart people (and there are quite a few at both Goldman and KKR) sometimes do stupid things.  No one is immune from the "herd" mentality. Goldman and KKR were caught up in the mood of the moment - debt  would remain cheap and the economy would keep growing forever - and the deal was reflective of these views.
2. First principles in finance are like first principles in physics. If you violate them, they will catch up with you, no matter who you are. What are these first principles? Here is one. If you are a business that does not generate high cash flows right now, even though you may have great growth potential, you should not borrow money (even if there are people out there willing to lend you this money).
All of this pontificating brings me to Blackstone's earnings announcement due today. My guess is that "marking to market" all of their deals will have a devastating impact on their earnings. No one should be surprised and Blackstone is not alone in feeling the pain, but the lesson we should take away is that private equity and hedge fund investors make the same mistakes that other investors make - the only difference is that they do it on a bigger scale.


Saurav Roychoudhury said...

Read your paper about "The Anatomy of an LBO: Leverage, Control and Value". Very good dissection and it would make a classic case study for MBA. The escapade of GS and KKR did cost Harman (HAR) an enormous drop in shareholder value. On September 19, 2007 the price of HAR was 112.30 and on November 5, 2008 it is reeling around $18.00.
About Blackstone, their quarterly results did turn out to be really bad which was bound to happen as you predicted. Their 'forward looking' statement was that unless market conditions improve, they may have to cut their dividend significantly, or "possibly (declare) no distribution at all."
I am wary of Private equity funds going public. The ownership and governance structure of publicly traded 'private' equity firm significantly increases agency costs relative to a private 'private' equity firm. Well, what to say, the investors in BX did not beleive that, certainly not the Chinese who made their $3 billion gamble.

Unknown said...

Hi Prof,

1.Could you please explain what is the safe boundary line for a company going for debt financing ?

2.A company's earnings growth depends on capex and needs debt financing, most of the time. So debt being a necessary evil, what policy measures can save a company from being excessively leveraged ?

Anonymous said...

Nice article Prof, unfortunately from where i come from, there are still those who are well connected and influential who swear by the Blackstones and the Carlyles, claiming '...they deliver value. Period.'

Charles.Widdicombe said...


Good point about first principles of finance. Maybe this topic could be a blog topic in its own right, since I wonder how you could distill these "first principles" of finance into 10 points, and what they would be (out of the myriad of possible answers). It may be a good discussion point as well as to what principles make it to the list.