On safe ground – for now

The credit crunch is now officially recognised as the worst market crisis since 1929, and everyone working in financial services is suffering.

Everyone? In the epic drama currently being played out in the financial world, private equity doesn’t seem to have been given a part. Credit to the infatigable Christopher Flowers in New York, to whom apparently no turnaround challenge can seem too big: after everyone else had made for the hills, Flowers was still declaring himself willing to help rescue first Lehman Brothers and then AIG, thus keeping private equity in the headlines almost singlehanded. But his was a mere cameo (and, predictably perhaps, achieved nothing). The spotlight, meanwhile, remains resolutely focused on others.

As the market catastrophe unfolds, all the attention is on the banks and, in the form of AIG, the insurance sector. They have become bywords for corporate irresponsibility on a hitherto unimaginable scale.

Equally under fire now are the hedge funds, whose relentless short-selling is now widely and furiously being blamed for the collapse of otherwise supposedly healthy, or at least curable, institutions. Ask the man in the street about HBOS for example, Britain’s largest mortgage lender which on 17 September fled into the arms of Lloyds TSB, and you’re likely to be told that it was the hedge funds that did it.

Private equity on the other hand is seen as having little to do with any of it. Rightly so, one might add. Whoever is to blame for the disaster, it isn’t private equity. Buyout funds certainly took advantage of a market that priced debt cheaply and ignored risk. But did they create the conditions that made the credit boom possible in the first place? They did not.  

The question of blame isn’t as trivial as it may seem. To the industry’s detractors, private equity’s lack of culpability must be galling, given their long-standing desire to cast LBO funds as the chief villains of the capitalist piece. To the industry itself, current sentiment is a welcome respite from the unyielding fury that kept coming its way right up until the buyout boom ended last year.

Private equity owes the relative comfort it enjoys at the moment to the resilience of its funding model: with investors’ capital locked in for the long term, general partners can afford to do nothing. Whilst banks are staring into the abyss of bankruptcy, and capital redemptions threaten to overwhelm hedge funds, private equity groups can sit tight and wait for the hurricane to blow over. In an out-of-control environment such as today’s, this is an advantage that cannot be overstated.

What the industry worries about instead is what comes after the storm. For the expensively purchased and aggressively leveraged businesses in recently assembled buyout portfolios, the key question is what happens if the financial crisis paralyses the economy, and earnings collapse. Thus far, even though the world economy has been slowing, this has not happened.

Anecdotes from the private equity frontline confirm this. In mid-September for example, the boss of one of the largest global fund of funds investors told me that for the 6,000 or so companies in his firm’s portfolio, EBITDA was up 7 percent on average relative to last year.

This is earnings growth on average, mind. There are of course exceptions, and those of a pessimistic disposition will be quick to wonder whether private equity-backed businesses struggling already are merely suffering the same fate early that will soon catch up with many.

In the UK, the BC Partners-owned estate agent Foxtons is one company that could be seen as a herald of the pain to come. Bought just weeks before the credit crunch started in 2007, BC modelled the deal on the assumption that property sales in Britain could not fall by more than 30 percent. Such a big slow down had never happened before, but then who could remember a financial crisis of this magnitude? When the UK mortgage market died, BC’s model turned out widely optimistic. House sales are down more than 50 percent, and Foxtons is a troubled deal.

BC may yet rescue the business, for instance by injecting fresh equity. Indeed, working hard with the portfolio to get through tough times could well become the dominant private equity theme of 2009. But for the time being, the industry is still on relatively safe ground. At a time when the fabric of global finance is changing beyond recognition, and no one knows what the future holds, it’s a pretty good place to be.