The ‘perfect calm’ of private equity prepares for storms

BVWireIssue #59-5
August 29, 2007

The history of finance makes one point very clear: near perfect conditions, although intrinsically rare and invariably extrapolated by market participants—almost “invariably regress to more normal conditions,” writes Jeremy Grantham, chairman of fund manager GMO, in a recent article for the London Financial Times

For the last several years, private equity has existed in a “perfect calm,” enabled by low interest rates, friendly credit, easy leverage, and rising global profit margins.  But when the inevitable regression happens to today’s record profit margins, Grantham says, “all but a handful of private equity deals will lose money and many will lose it all.  At a five-year horizon, even managers who could add 30% to the efficiency of their firms would lose all their equity in highly leveraged deals.”  And of course, “more typical deals that add little or even detract value would do much worse.”  Normal capitalistic competition will drive profit margins for PE-owned companies back down to historically “correct” levels, and when that happens, Grantham predicts, get ready for the perfect PE storm.

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