Monday, September 10, 2007

For Whom the Bell Tolls

Gandalf had hardly spoken these words, when there came a great noise: a rolling Boom that seemed to come from the depths far below, and to tremble in the stone at their feet. They sprang towards the door in alarm. Doom, doom it rolled again, as if huge hands were turning the very caverns of Moria into a vast drum. Then there came an echoing blast: a great horn was blown in the hall, and answering horns and harsh cries were heard further off. There was a hurrying sound of many feet.
"They are coming!" cried Legolas.
"We cannot get out," said Gimli.

— J.R.R. Tolkein, The Fellowship of the Ring

Andrew Ross Sorkin is dancing a happy jig on the freshly filled grave of the private equity boom, and he wants you to know that you're next:

Comfortable? Let me offer a more dour view: wide swaths of Wall Street, and many of the industries that serve it, are in for some serious collateral damage. Not only has private equity been out of business for the last two months, but that activity is not likely to resume with any significance soon. And when it does, it will be at a fraction of its recent peak.

So what does that mean? For much of Wall Street, a severe case of withdrawal. Forget about cutting the size of bonuses: let’s start really thinking about the possibility of slashing jobs.

In his Sunday New York Times DealBook column, Sorkin goes on to identify a few of the likely victims: financial sponsors group bankers, private equity professionals, "irrational compensation packages" on Wall Street, management consultants, eager MBAs, and—cruelest of all—poor little SeamlessWeb, which delivers food to hungry analysts pulling all-nighters.

Well, shit, Andrew. Pull out the black armbands, why don't you?

The trouble is that Sorkin both goes too far in some respects and doesn't go far enough in others.

For one thing, he mentions irrational compensation in the same breath as private equity's 2% management fees, leading the uninformed reader to draw the conclusion that 2% of assets under management flows directly into the pocketbooks of a PE firm's professionals, with nary a stop for tea. Nope, sorry, my boy, that 2% counts as revenue to the PE firm, which must unfortunately be offset by such pesky little items as the expenses of running the business. Believe it or not, renting swanky offices on Park Avenue or 57th Street in Manhattan tends to chew up a great deal of that filthy lucre right out of the box. Then, of course, there are all those consultants the PE firms hire to do due diligence on deals and potential deals. While some of the outsourced services the PE firms use can indeed be charged back to its limited partners for successful deals, as Sorkin mentions, in most cases the GP cannot charge for due diligence on deals it does not close. And every PE firm out there takes a deep look and spends a lot of time and money on deals it does not win. No, it is an expensive proposition to run a PE firm, and very few GPs get rich on management fees alone.

Second, Sorkin misses or fails to mention vast swathes of the financial landscape which have luxuriated in the explosive growth of the private equity biosphere. In addition to management consultants, among those who have staffed up dramatically to serve PE clients in recent years, you can add accounting firms, sell-side investment banks, virtual deal room providers, data service providers, leveraged finance bankers, and lawyers. Had you attended one of the umpteen thousand private-equity-centered investment conferences in New York or elsewhere in the past few years, like I did, you would have been amazed at the number and diversity of service providers all jostling to lick the boots of their PE masters. Because they are so thinly staffed, private equity firms outsource practically everything. Now that PE deal volume is down, and likely to stay depressed for some time, things are going to get a mite sketchy out there on the savannah. With fewer lion, leopard, and cheetah kills to scavenge, the hyenas, jackals, and vultures are going to get mighty hungry.

Compounding this lack of joy in Mudville is the coincident carnage in the hedge fund community and at investment banks. Bankers and investors who could not distinguish Henry Kravis from Angelina Jolie are getting roiled by the same forces pummeling the credit markets which serve private equity, and cumulative net worth among these participants is disappearing faster than a cold beer on a hot day. All of Wall Street is taking it squarely on the chin (or chins, depending on your view of how fat those cats really are).

This means that the secondary fallout from this uproar will be pretty broadly distributed, some of it in places which on the surface seem far removed from the intersection of Wall and Broad. My favorite candidates include high end New York apartments, commercial rents in Midtown, vacation homes in the Hamptons, New York City tax receipts, Ferrari dealerships, "bottle service" at trendy nightspots, second and third rate contemporary art, and $3 hotdogs from Manhattan street vendors. I would expect a similar deflation of balloons in other financial centers as well, with London leading the way for Europe.

So while I enjoy a good session of Schadenfreude as well as the next guy, and appreciate a little grave dancing in the financial media to boot, I must in all honesty observe that all of us are going to feel some pain from this contraction. Not least of these, of course, will be journalists like Mr. Sorkin, who have hitched their rising star to the deal economy chariot just like the rest of us. And while he will no doubt be able to write some juicy stories of the decline and fall of financiers great and small, at the end of the day who will read his column if none of us are left?

No man is an island entire of itself; every man is a piece of the continent, a part of the main. If a clod be washed away by the sea, Europe is the less, as well as if a promontory were, as well as if a manor of thy friend's or of thine own were. Any man's death diminishes me, because I am involved in mankind. And therefore never send to know for whom the bell tolls: it tolls for thee.

— John Donne

© 2007 The Epicurean Dealmaker. All rights reserved.