Blackstone's Woes: Some thoughts on Private Equity

About a year and a half ago, at the height of private equity's success, I put together a presentation on LBOs that examined what makes an LBO work and, conversely, why many of them were destined to fail. The LBO I looked at was the Harman deal, backed by two big names - Goldman and KKR. Based on my analysis then, I concluded that Harman fit none of the requirements for a good target - it did not have significant debt capacity (nullifying the leverage benefit), it was well managed (eliminating the restructuring need) and did not suffer any serious separation between management and ownership (countering the going private argument). If you are interested, I have a paper describing the deal that can be downloaded by going to: 

http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1162862

My purpose in the paper was not to pick on Goldman and KKR but to make the following points:

1. Even smart people (and there are quite a few at both Goldman and KKR) sometimes do stupid things.  No one is immune from the "herd" mentality. Goldman and KKR were caught up in the mood of the moment - debt  would remain cheap and the economy would keep growing forever - and the deal was reflective of these views.

2. First principles in finance are like first principles in physics. If you violate them, they will catch up with you, no matter who you are. What are these first principles? Here is one. If you are a business that does not generate high cash flows right now, even though you may have great growth potential, you should not borrow money (even if there are people out there willing to lend you this money).

All of this pontificating brings me to Blackstone's earnings announcement due today. My guess is that "marking to market" all of their deals will have a devastating impact on their earnings. No one should be surprised and Blackstone is not alone in feeling the pain, but the lesson we should take away is that private equity and hedge fund investors make the same mistakes that other investors make - the only difference is that they do it on a bigger scale.