In praise of market timing

Deals born bad are not often saved by operating partners

Possibly the most overused line of faux-self-deprecation in the history of private equity is: “We're not smart enough to time the market.”

The self-inflating follow up to this is usually a description of the GP's amazing ability to squeeze profit from a deal through brute operating force.

But let's now acknowledge that the industry would be in far better shape if more GPs were just a little bit smarter about market timing, if one is to define this as endeavouring to mostly buy low and sell high through multi-year cycles.

In a way-off-the-record interview, the head of a major US endowment's private equity programme proclaimed that over the next several months he was going to ask some tough questions of the general partners in his portfolio. “I want to know why they raised their largest funds ever, then spent these as quickly as possible at the very height of the market using incredible amounts of debt,” he said.

As you'll note on p.33, almost all of the largest deals of all time coincided with historically high purchase price multiples and debt-to-equity ratios. In retrospect it seems clear that this was a time to be selling, not buying, on average.

It would appear that most GPs experienced a form of temporary insanity brought on by excessive exposure to leverage. Most of the largest GPs were net buyers during this period. As reported on sister news service PrivateEquityOnline in late August, only 10 of the largest 50 private equity firms in the world were net sellers of assets during the five years ending April 2009, according to information provider Dealogic.

Private equity GPs are paid to source attractive investment opportunities, structure smart acquisitions, add operating value, and exit at maximum value. What you don't often hear is that they are paid to make judgments on macro conditions, i.e., time the market.

In truth, many GPs were already preparing their LPs for a lower return scenario well before the credit apocalypse of 2008. In between doing 11-times-EBITDA mega-buyouts, these GPs paused to surmise that the net returns from these deals might not be as impressive as deals done in less buoyant times. They began gently explaining this to LPs and describing a new paradigm, one in which value would be enhanced through operating improvements and managerial prowess. These same firms began hiring former chief executives and division heads of industrial groups – operating talent unsullied by stints at investment banks.

It was the right idea at the wrong time, and in many cases with the wrong execution. Sad to say, but all the operating talent in the world wasn't going to save a deal that was overpriced, overleveraged and wobbling near the precipice of a severe recession. You could air drop Jack Welch, Louis Gerstner and Lee Iacocca into Chrysler and still come up with a zero return.

Some buyout-backed companies have indeed responded well to productivity and cost-cutting initiatives through the recession – but only some. These companies benefit from having enough cushion to respond to such initiatives, and from having the right operating team with the right incentives. Not every private equity firm got this right.

One investor source recalls joining a conference call between LPs and the chief executives of portfolio companies of a US private equity firm. One by one, the company bosses walked listeners through their plans for helping their firms weather the storm. After the call an LP remarked that he was relieved to hear the language of operations being used to describe the way forward for the portfolio. By contrast he described a number of other recent conference calls where GPs spent most of the time discussing debentures, loan renegotiations and debt buybacks. In other words – moves that have nothing to do with the underlying operations of the businesses. These were remedies to be executed by financial engineers to address problems created by financial engineers.

A market rumour recently squashed by CalPERS was nevertheless telling. The investment staff of the California pension giant were said to be now requiring psychological evaluations of GPs. Not true, said CalPERS. But let's be honest, if there actually were a test that could uncover a GP's predilection for charging into a deal stampede, everyone would be required to take it.