Tuesday, February 13, 2007

A Simple Request

In the course of an investment banking career spanning almost two decades, I have yet to meet a private equity professional who is wracked with doubt, paralyzed with uncertainty, or unsure about his or her own brilliance and effectiveness in the realm of investing. Perhaps this perception is not a true reflection of these peoples' character and beliefs, but rather just a pose they all adopt when meeting an investment banker, one of those low and despicable intermediaries who are only out to skim a fee and who never put their own capital at risk in any deal. I do not know.

This also seems to be a common attitude among those refugees and recruits from Corporate America who join financial sponsor firms as operating, adjunct, or advisory partners. I still remember a series of meetings a few years ago when a Senior Operating Partner at A Very Prestigious Private Equity Firm argued strenuously in one meeting that Portfolio Company XYZ absolutely needed to be characterized as an Industry A-type company in order to sell it in an IPO and just as strenuously argued that it was without question an Industry B-type company in a meeting two months later. Never mind that the company in question couldn't find its way out of an Industry A- or an Industry B-type paper bag with a map and a blowtorch. The only consistent attitude this partner had in both meetings was a complete and uttter disrespect for the (relatively well-informed) opinions of Yours Truly, Scum of the Investment Banking World. (And, having been a Divisional Vice President at A Very Prestigious Public Corporation, I can assure you that this person was not widely regarded as A Complete Idiot.)

Now, I do not know whether this uniform attitude of arrogant superiority and absolute certainty is a genetic prerequisite for anyone aspiring to join the ranks of private equity, or rather a protective carapace which an individual necessarily develops in the course of pursuing a successful career in the industry. My guess is that it is a mix, said guess being entirely based upon my personal knowledge of a small and non-representative sample of formerly nice, smart young investment bankers I have known who have subsequently been recruited to the Dark Side of the Force.

All that being said, I can appreciate why PE professionals display such traits. After all, the feat of buying a largely unknown entity with a fundamentally untested management team on a highly leveraged basis and then being required to hand-hold, prod, scream, and yell at various constituencies over a period of up to seven years in order to deliver a saleable entity whose exit value will be almost entirely at the mercy of forces completely out of your control does require a certain confidence in either fate or your own abilities. And if you do have any doubts, I am sure you learn to suppress them into nonexistence the first time you are required to defend your investment thesis in front of the sponsor's Investment Committee. After all, one does not draw attention to a nosebleed when one is immersed in a shark tank.

So, let's just agree that a—shall we say—robust ego is a necessary and appropriate prerequisite to being a successful private equity professional. So what? Well, I can see two risks.

The first, of course, is internal: hubris. Self-confident or not, any self-respecting PE professional has to admit there has been a terrific tailwind at his or her back for the last several years: abundant, cheap debt (with minimal or no covenants); strategic buyers frozen in the headlights like rabbits; and chunky realized returns boosted by relatively depressed entry multiples from the 2001 – 2003 investment period. In other words, you cannot realistically take credit for all of the success you have enjoyed. You may indeed be Good, but do not underestimate the fact that you have also been Lucky.

The second risk is external. Private equity has gotten so prominent in today's society and economy (vide The Carlyle Group's recent apothoesis on the cover of BusinessWeek and the dust up surrounding Steve Schwarzman's 60th birthday bash), that attention is being directed from many quarters at an industry that has not made a practice of justifying itself in public. And, let me tell you, you need a little justification, notwithstanding all your good work.

Think about what that old chestnut of behavioral economics, the Ultimatum Game, tells us. When they have a veto power, most people will punish someone who attempts to take "too much" of the pie by guaranteeing that no-one gets any pie. This is not "rational," in a strictly economic or game theoretic sense, but it is an observable behavior trait across many different societies and cultures. And kid yourself not, veto power is exactly what many of the social, political, and investment constituencies beginning to question the value of private equity have. How would you like to have the tax deductibility of corporate interest expense limited for highly levered transactions in this country, as has been mooted in a few corners? I didn't think so.

So, for your own good—and the good of the economy to which you contribute so meaningfully—do us all a favor: Make nice.

© 2007 The Epicurean Dealmaker. All rights reserved.