Leveraged Funds Need to Face the Music

It's not denial. I'm just selective about the reality that I accept.
Bill Watterson, author of Calvin and Hobbes cartoon series

Many private-equity and hedge fund managers are facing a perfect storm of economic and credit challenges that threaten to destroy their businesses. Unfortunately for their investors, rather than face these challenges head-on, many of these managers are choosing to emulate their lenders and pretend that these problems don't exist or are just a temporary bump in the road.

This strategy of hope and denial by private-equity and hedge fund investment managers does not benefit their limited partners and in many cases does not benefit the manager in the long run; it will lead investors to pull out their money and never return to those managers who lose credibility.

There is a better way for managers to handle the crisis that they're facing, but first let's examine the severity of the problem.

Nearly all leveraged private-equity funds and hedge funds that were focused on leveraged buyouts or leveraged real estate investments are facing enormous losses in their funds. That includes, to name just a few: Blackstone(BX Quote), Fortress Investment Group(FIG Quote), Farallon, Lubert Adler, Broadway, Whitehall, Perry, D.E. Shaw, D.B. Zwirn, The Carlyle Group, KKR, Cerberus, et al. I am not singling out any of these firms. Every private-equity fund and hedge fund that entered levered real estate and corporate buyouts for the last several years is facing the same situation.

The problem is that during this down cycle the interests of the managers and the limited partners are no longer aligned. Managers want to hide losses and hope the values of their bad investments recover so that they don't have to face the wrath of investors for losing so much of their money.

Unfortunately, this strategy of denial makes the problems and losses even worse because it makes it impossible for the manager to take the appropriate and necessary steps to recover value for the investors. Managers can't do the right things to fix the problems if they keep denying that the problems exist.