The Toast Of The Town, Toasted

Probably the most spectacular asset class of the late and lamented Great Bull Market was private equity (PE). All the big professional investors poured money into PE, for the same reason Willie Sutton gave. At his sentencing for armed robbery, the judge asked, "Mr. Sutton, why is it you always rob banks?" Sutton replied, "Judge, because banks are where the money is." Now, like Sutton, the private-equity pros are going to be punished for their sins.

The returns from PE have been spectacular. The consulting firm Cambridge Associates calculates that between 1986 and 2006, private equity had inflation-adjusted returns of 11.23 percent annually. At that rate, your money would grow 189 percent in 10 years. What endowment wouldn't be entranced by that kind of enhancement?

However, in order to get those returns, PE firms required immense leverage in the form of high-yield debt, and a friendly equity market. The formula was to identify a struggling company, acquire it using high-yield debt, improve the company operationally and then sell it back to the public via the stock market. Bear in mind that before they got respectable, PE firms used to be called LBOs, or leveraged-buyout firms, and high-yield debt was referred to as junk bonds.

PE firms used financial-engineering tricks, such as having the company sell a high-yield-bond issue and then using the proceeds to pay a special dividend to themselves, but that was a minor part of their business model. The high-yield-debt and IPO markets were the essential ingredients, and until the credit tsunami hit, there was huge appetite for both.

The situation now is that existing PE portfolios are stuffed with cyclical companies with leveraged balance sheets bought at prices based on formerly high earnings, which are not likely to return. This a lethal mixture in the sickest economy since the Great Depression.

There are puddles of blood on the floors of stock exchanges, so theoretically there should be PE opportunities. However, there is no financing available to acquire companies, much less to leverage acquired companies. The cost of high-yield debt, PE's currency, has skyrocketed. The average spread of high yield over Treasuries from 2003 to 2006 fluctuated between 300 and 500 basis points (bps), or 0.3 and 0.5 percent. Over the last 21 years it has averaged 535bps. Today it is 1,488bps, an astonishing figure in an industry that counts every hundredth of a percent. Since investors are terrified by the spreading economic weakness, new issues of junk bonds are almost impossible to place, and the debt-servicing burden would be so high it would crush the issuing company. Existing junk-bond yields are at an all-time high of 19.2 percent.

The PE business relies on leverage. David Swensen of Yale points out that if you had leveraged up the S&P 500 by the multiple used by PE firms, the return on your S&P fund would be far higher than the returns of the vast majority of PE firms. His point is that the average investor in PE is not compensated for the extreme risk of leverage and for the immense nonliquidity. Yale has earned more than 30 percent a year from its PE portfolio, but Swensen argues that you must invest in only the very best PE firms that aren't too big and that concentrate on improving the operating performances of their portfolio companies.

That PE has come on hard times is no secret, but no one knows how hard and how long the dry spell will be. Since their positions are not traded, PE firms use various opaque methods to value their portfolios, so the extent of the losses may be concealed for a while. The last dry spell lasted for three years; the one before that, four. Some years the returns were single-digit negative, but not disasters.

Meanwhile, there is a secondary market in the major PE funds. According to my sources, buyout funds are selling at discounts of 40 to 50 percent. The story is that Lehman Brothers had to accept bids down 50 percent from stated value for portions of its PE portfolio. And that was before things got really rough. Now a number of major PE holders—supposedly including Harvard, Duke and Calpers—have sold or are trying to reduce their allocations to PE. But buyers are pulling back, wondering if the stated valuations are realistic. The value of Harvard's endowment, the biggest university endowment in the world, fell from $37 billion on June 30 to $24 billion at the end of October.

It's the end of an age. PE became the destination of choice for the most brilliant M.B.A.s, always a bad omen. The great PE moguls, like Henry Kravis of KKR and Steve Schwarzman of the Blackstone Group, became the toasts of New York and London society. Schwarzman's 60th-birthday gala cost millions of dollars and was the extravaganza of the new era, and when he took his firm public in June 2007 he alone brought home more than $677 million. Blackstone has so far reported a loss for this year, and the stock has fallen from a high of $35 to a current price of $4.65. The guess here is that PE as an asset class will show losses of 8 to 12 percent for the next three or four years. And without leverage, the glory days are over for good.