Napoleon in winter

Every PIPE is different, but today's disasters bear an important resemblance to the tech PIPEs of yesteryear, writes David Snow.

Those who fail to study history are destined to repeat it. But even those well aware of history have a hard time sorting out the repeated from the unprecedented.

Take for example the current economic crisis and its effects on the private equity industry. Market participants are running out of superlatives to describe this mess. And yet while the severity of this particular Wall Street collapse may exceed previous crises by several degrees, we've seen problems like this before. With this in mind, an argument can be made that at least some GPs failed to take lessons from Napoleon's wintertime assault on Russia, as it were.

David Snow

For example, to what extent does TPG's specular WaMu loss look like Forstmann Little's spectacular XO Communications and McLeodUSA losses? There are many important differences, to be sure. Both of Forstmann Little's competitive local exchange carriers (CLECs) were profitless telecommunications ventures in sore need of capital but with unproven business models. Washington Mutual was the biggest home mortgage provider in America. The company had fallen on hard times for reasons entirely different from the CLECs of the late 1990s.

But a look at the state of the private equity industry in both 2000 and 2008 shows striking similarities that, applying a small dose of warranted cynicism, partially explain how both Forstmann Little and TPG ended up with busted PIPEs. In both periods, the buyout business was hampered by a reluctance on the parts of banks to provide leaverage. In the case of 2000, a credit crunch starting 18 months earlier meant that buyout firms had plenty of capital but little in the way of LBO deals to pursue.

Rather than hand undrawn capital back to investors (which would run counter to any argument that the next fund needs to be really, really big), buyout firms put it to work in large slugs of equity, primarily in the form of private investments in publicly traded telecom entities.

In 2008, large private equity firms, even more well heeled but with buyouts off the table, were highly incented to pursue PIPEs and other non-buyout strategies, like debt acquisitions. Regardless of the merits of the target companies, the controls and possible outcomes for PIPEs are very different than they are for buyouts.

Ultimately the WaMu fiasco may have been a “black swan” and therefore not predictable by reference to history. But given the huge disparity between undrawn capital and buyout opportunity, TPG and others are going to have a lot of explaining to do when asked whether they failed to resist perverse incentives to invade dangerous territory.