Kass: Private Equity Is the Next Shoe to Drop

Midteen cash flow multiples against peak earnings were routinely paid, and the uber aggressive pricing of deals far in excess of tangible values produced monstrous goodwill accounts. It got so bad over the last few years of the takeover cycle/bubble that the private equity firms began to downstream large dividends to themselves immediately or soon after the deals were consummated, thereby levering up the capital structures to the point at which the investors in the equity and the subordinated debt of the deals were almost doomed at birth and, in all likelihood, ultimately leaving morsels of any value only to the senior lenders.

In essence, like their hedge fund brethren (whose dirty little secret was that they were levered capital pools), private equity firms took uncommon risk (debt and leverage) in producing common returns. Stated simply, the early (historical) successes seen in private equity returns were an illusion. The foundations of private equity deals, similar those of securitizations (in mortgages and elsewhere), were cracking as the money poured in under the appearance of good investment performance.

While the recession continues to emerge and the credit markets remain seized up, years of positive returns (both real and make-believe) are now going up in smoke. (Watch for some major university endowments, whose returns were buoyed by impressive private equity returns, to report large losses in the asset class in their current fiscal year.)

Like post-2005 vintage mortgage lending, most private equity deals done over the last two and a half years (estimated at over $900 billion) are now worthless (as are some of the early vintages). Unfortunately, those unrealized losses have not even been reflected in the marks of private equity investors (including many hedge funds) around the world, who are likely to see their own Black Swan event in the near future.