Kass: Private Equity Is the Next Shoe to Drop

This blog post originally appeared on RealMoney Silver on Oct. 30 at 8:10 a.m. EDT.

"I've been in a hurry all my life. I've been in a hurry to succeed, and in a hurry to prove myself."

-- Henry Kravis
The casualty count in the world of finance is about to expand in scope.

At the epicenter of the leveraged binge of the last decade were the private equity shops' "deals." These firms funded their "products" to individuals, endowments, hedge funds and to other institutions around the world with the promise of turning waste into gold.

There were few secrets to their alchemy, which was borne out of highly leveraged transactions of often rather unattractive corporate takeovers in mundane and cyclical industries (contained for all to see right in their pitch books).

The structure of the compensation of the private equity firms favored their managers over their investors in their deals. This is not unlike the avaricious compensation schemes that were made available to those wonderful folks on Wall Street who gave the world a new generation of dirty bombs -- namely, derivative and securitized products. Those financial weapons of mass destruction have seized our credit markets in 2008, irreparably poisoning our financial institutions and leading to large investor losses.

For a while, things went smoothly. Investors in the leading private equity firms -- Blackstone ( BX), Cerberus, Fortress ( FIG), etc. -- poured unlimited money into their coffers as steady returns buoyed investors' appetites and produced much-needed non-correlated alpha (excess returns). Indeed, Stephen Schwarzman, Henry Kravis, Stephen Feinberg and their ilk became the new masters of the universe.

Soon thereafter, others got into the act, and, in the fullness of time, many large hedge funds got into the hunt, serving to raise target prices to unrealistic valuations. As the private equity bubble inflated, deal valuations got as carried away as non-documented mortgage lending, perhaps even more so.

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.

Worse yet, many of those investors now face capital calls to support poorly structured deals in which cash flows are now hemorrhaging in a deteriorating business backdrop. Importantly, these capital calls will result in a crowding out of inflows into other alternative strategies -- for instance, last week Calpers announced that its private equity calls will result in lower commitments to other hedge fund asset classes.

Based upon the new economic/credit realities, it is not surprising that the shares of publicly traded private equity shops are now priced at hat sizes.

Don't be tempted by their large share price declines in 2007 and 2008; they are value traps.

And for investors in private equity deals that were put in place over the last five years, the outlook is even worse, as they are generally illiquid and only now are beginning to be marked down in price.

Private equity will be the next shoe to drop.

But, hell, maybe the Treasury Department will save them, too!

Doug Kass writes daily for RealMoney Silver , a premium bundle service from TheStreet.com. For a free trial to RealMoney Silver and exclusive access to Mr. Kass' daily trading diary, please click here.

At the time of publication, Kass and/or his funds had no positions in the stocks mentioned, although holdings can change at any time.

Doug Kass is founder and president of Seabreeze Partners Management, Inc., and the general partner and investment manager of Seabreeze Partners Short LP and Seabreeze Partners Short Offshore Fund, Ltd.

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