The Toast Of The Town, Toasted

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.

Biggs, the famed Wall Street strategist, is a managing partner with Traxis Partners hedge fund in New York.

© 2008