Henny Sender in the Wall Street Journal has an interesting piece on how private equity firms are simulatenously extracting significant fees from their investments and generating large dividends via expanded leverage. This is a change in the way private equity firms do business. In a way they are front-loading their returns, in contrast to the ‘patient’ way they used to operate.
There is nothing untoward in what they are doing, but the risk is that there is a heightened risk of financial distress.
Some worry that by heaping enormous debt onto their portfolio companies to help pay the dividends, private-equity firms heighten the risk that the companies may fail if the economy stumbles. Should it “be about how far you can push things or should it be about how much flexibility you give your companies to deal with the unexpected?” asks Josh Lerner, a professor at Harvard Business School who has done research on the performance of private-equity firms. “You can see reason to worry in how much [money] they are pulling out.”
Edward Hadas at breakingviews notes that George Roberts of KKR recently told the FT that LBOs will outperform over the long run due to shrewd investments and careful due diligence. Hadas wonders whether Roberts’ viewpoint is due in large part to the favorable investment conditions that have existed for quite some time.
Roberts and Kravis have a good record behind them. But they have been able to row downstream. For all their skill with the oars, the current of favourable financial conditions have been doing most of the work. Real interest rates, which have fallen dramatically over most of KKR’s life, remain low. Credit spreads are narrow and debt is readily available in quantity – not to mention good growth in almost the whole world and record corporate profitability.
The going will get much rougher when the industry hits some financial or economic rapids. Then the confidence that debt is good and more debt is better could look, well, reckless.
The chickens outlined in the WSJ piece may never come home to roost. However if we do experience any economic instability there is a chance that some of these private equity investments will become stressed.