Economy: McKinsey Predicts the Future of Private Equity

During 2007, there were several subtle signs that the global boom was peaking: Fortune crowned Blackstone Group CEO Stephen Schwartzman as the new king of Wall Street , Fox Business Channel made its debut, and we saw the first inklings of disaster in the subprime mortgage market. But in retrospect, the most obvious omen was that all too many people were assuming that the boom of the previous three years would continue for the foreseeable future. Such sentiments weren't confined to CNBC's studios. In October 2007—the precise market top—McKinsey Global Institute, a think tank nestled in the confines of the blue-chip consulting firm McKinsey & Co., issued a report documenting the stunning rise of four comparatively new pools of capital—hedge funds, private-equity firms, Asian sovereign capital (Asian central banks and sovereign wealth funds), and petroleum exporters (companies, governments, and central banks of oil producers). These new power brokers had been major beneficiaries of recent trends in the global economy. And if existing trends were to continue—and why wouldn't they?—they'd be even bigger in a few years.

As the executive summary noted (here's the whole report), in mid-2007 that group collectively held $8.4 trillion in assets, more than triple the amount they held in 2000. But that was just the beginning. "Under current growth trends, MGI research finds that their assets will reach $20.7 trillion by 2012." But even if things didn't go quite as expected, they'd still rise to $15.2 trillion by 2012, nearly doubling. And the impact of these power brokers would be even greater than implied because of the ability of hedge funds and private-equity funds to use leverage (i.e., debt). Hedge funds had $1.5 trillion in assets but controlled several times more than that.
While highlighting the risks each of the new power brokers could pose by growing so large, the report utterly failed to sniff out the systemic risks this gang was already posing in the fall of 2007. Like virtually every professional economic-forecasting outfit, McKinsey's crew failed to see how the easy money created by the rise of Asian sovereign wealth and petroleum exporters would be put to spectacularly bad use by private-equity firms and hedge funds. It also failed to entertain the possibility that the global economy could shrink for the first time in more than 60 years. And it failed to see how the power brokers, who reinforced one another's rise, could reinforce one another's fall. Exhibit A: Chinese and Persian Gulf sovereign wealth funds lost billions of dollars investing in U.S. private equity firms and financial services companies.

Two years later, McKinsey has issued a new report assessing how the power brokers have handled the financial crisis. At the end of 2007, they had a total of $12.7 trillion in assets among them; in 2008, they had $12.1 trillion. The primary loser was the hedge fund industry, whose assets fell to $1.4 trillion in 2008 from $1.9 trillion in 2007 and have probably shrunk further since.

On the one hand, the report reflects a chastened reality. On the other hand, readers can detect in this report the same intellectual tendencies that led MGI astray: the assumption that trends from the recent past will be extended neatly into the immediate future.

The 2007 report projected more of the same—assets of these guys tripling in the previous seven years and hence potentially tripling again in the next six—and so does the 2009 report. Private-equity firms and hedge funds have been struggling since 2007 and will therefore continue to do so. The 2007 report projected hedge funds would have $3.5 trillion by 2012. Now MGI says they'll have only $1.5 trillion in 2013—essentially flat with the 2008 total. The 2007 report projected private-equity funds would have $1.6 trillion by 2012; now it says they'll have $1 trillion in 2013, again essentially flat with the 2008 total. Meanwhile, MGI presumes that the long-term trends and the even longer-term blessings of geology that have channeled dollars into coffers in Asia and the Persian Gulf, respectively, which continued through the recession (people still need manufactured goods and oil during a downturn), will continue as the global economy recovers. By 2013, Asian sovereign investors will have $7.5 trillion, more than double their 2007 total, and petroleum exporters will have $8.9 trillion, nearly triple the 2007 total.

Of course, you don't have to be a management consultant to know that simply projecting recent trends into the near future—forecasting by extrapolation—is dangerous, especially today, when volatility and discontinuities are rampant. A scant two years ago, MGI's brainpower was unable to foresee the forces that would cause hedge funds to take a tumble and private-equity deals to blow up. The research for this report, likely conducted earlier this year, doesn't seem to entertain the possibility that the trends sending dollars to Asia and the Persian Gulf could be interrupted. For example, there's been an astonishing fall in the volume of global trade since September 2008, and projections of oil consumption have recently been throttled back. And a host of events—a pandemic, domestic unrest in China and Iran, threats of war, technological breakthroughs in alternative energy, a desire to move away from the dollar as a reserve currency—could easily disrupt the flow of money to the power brokers by 2013. In the first half of 2009, in fact, all of those things happened.