Worst five industries for 2009 (2)

For the first installment of this post (on the woes afflicting the retailing industry), go here.


#2 Private Equity

The entire industry’s business model has been left in tatters by the financial crisis, and there is no likelihood at all that it will bounce back in the near future. The mega-deals that powered the industry’s earnings over the past decade are now ancient history, as is the leveraged borrowing on which these deals depended.

The publicly traded debt arms of private equity firms have already been hammered into oblivion throughout 2008. In today’s Financial Times, reporter Henry Sender commented on KKR Financial’s (NYSE:KFN) recent woes, writing:

The debt arms of Carlyle and TPG, KKR’s main rivals, have also fared poorly, a sign that private equity firms are not always successful when they diversify out of the areas of their core strength.

The move [toward new management and direction] comes as KKR maintains the goal of following Blackstone to a listing. But prospects for such a move soon seem elusive. Fortress Investment Group, the private equity and hedge fund firm that began the trend when it went public almost two years ago, also saw its shares fall below $1 this month.

Many listed funds linked to private equity and hedge fund firms have suspended dividends after being doubly hit by a slide in their share price and investor redemptions from their funds.

The real problem is that private equity’s “core strength” is no longer applicable in today’s financial and macroeconomic environment. The pattern of effecting a leveraged buyout, performing a little financial engineering, cutting costs, and then spinning the company back out into the market at a 3x or 4x multiple is not going to work, especially when the initial transaction depends on 80% debt. In order to consummate these buyouts, PE firms are going to have to put more skin into the game, say, 50% equity; however, this is not the model of investing that most PE investors signed up for. Most PE investors, especially pension funds, never imagined that they would see that much of their capital at risk in a buyout scenario.

Many private equity firms still have substantial commitments from key investors, but the landscape has shifted such that it will be hard to deploy the capital in a manner consistent with the investors’ expectations.

Lacking that engine for earnings growth, private equity firms are just a collection of small debt funds and debt-laden portfolio companies, and we all know how well those did in 2008.


The Survivors

Obviously, there will be survivors, but given the famous lack of transparency in the industry, it is difficult to figure out their identity. Much like the financial conglomerates, private equity firms are masters of financial sleight of hand, and even should a few of them post strong earnings in 2009, I suspect they will suffer from the same kind of share-price discount that afflicted Citigroup (NYSE:C) during much of the last boom cycle. No one wants to pay dearly for a stock when the balance sheet cannot be deciphered.

In any event, I would steer clear of all publicly traded debt funds. Unless you are a financial whiz (and sometimes even that’s not enough), the underlying business is too difficult to understand. I suspect several will become insolvent during 2009, and with the mother ships undergoing a fair amount of distress themselves, it is likely that many debt funds will be allowed to go under.

If you must invest in private equity firms, getting a slice of the mother ship is about the only option here, but caveat emptor – it is distinctly possible that one or more major private equity firms will blow up in 2009. Vanity Fair’s Michael Wolff recently explored that premise, enticing his readers with a blockbuster lead-in: “At a lavish conference in Monaco, the game was guessing which big private-equity firm will be first to go bust.”

If you still believe in “smart money,” even after Bernie Madoff’s Ponzi scheme, even after Wall Street’s avarice crashed the entire investment banking industry, then be my guest and throw your bets down on private equity, but my advice is to look elsewhere.