From the WSJ (subscription required):
So let's take this step by step:
Step 1: So when it has reached the point that it is front page news in a major publication that "everyone knows" they are engaged in a game that will not last, it is time to batten down the hatches.
This is why we will see the market-top calling IPOs of the mega-PE funds this spring.
In a frank moment several weeks ago, Bill Conway, co-founder of private-equity heavyweight Carlyle Group, issued a directive to employees warning of a corporate debt market bubble. Wall Street bankers bluntly describe it as a house of cards, too.
So here's a question. If borrowers and lenders alike agree the corporate debt boom can't last, why isn't anyone stopping it?
Lenders have been doling out increasingly large sums of money and accepting increasingly crummy conditions and meager returns on their loans. Remember those "low-doc" loans that got subprime home buyers in trouble -- the ones that required minimal proof of ability to repay? These are their corporate cousins.
Waves of money are coming at the markets from investors around the world. Bond and loan buyers have to put this money to work, even if the deals are shoddy. In the last year alone, they bought up $148 billion in new junk bonds from U.S. issuers, the largest sum in history by more than half for such high-risk debt.
The fuller answer tunnels into the Street's cynical heart, and why it has always been so profitable to work there: Hedge-fund managers, buyout artists, and bankers get paid for short-term performance. The long-term consequences of their actions are, conveniently, someone else's problem.
People inside the big banks are eerily candid about the credit cycle creeping to an end. They also candidly admit they don't want to get caught missing the next big deal. Their banks, and their own bonuses, might suffer. So they ply ahead.
The incentives are just as clear for hedge-fund and other money managers: The more money they put to work, the more 2% management fees they collect. And if they can outpace the market, there's 20% of the profits in performance fees for the taking, too.
"The fabulous profits we have been able to generate," Carlyle's Mr. Conway said in a letter to his employees, resulted in large part from the availability of cheap debt. The bankers, he added, "are making very risky credit decisions."
Step 2: This is a repeat of what happened in subprime.
CLOs/CDOs funded by hedge fund managers with too much liquidity are taking stupid risks.
Structural changes in the way people buy and sell debt adds to the appetite. The Street's soothsayers say this has fundamentally changed markets, by spreading risk far and wide, like a rake shaping a deep sand trap into a large, shallow one.
Banks themselves have generally ceased their role as gatekeepers. They're now in the shipping business, not the storage business. They parcel out to other investors the big loan packages they cut, typically as much as 95% of the loans they originally underwrite. These are sliced and packaged into products and gobbled up by hedge funds, insurance companies and institutional investors hungry for anything with a sizable yield.
The slicing is supposed to disperse risk in a way that minimizes exposure to any one large default. The changes give comfort to a market that has shown precious little sign of cracking. In such conditions, chasing bad deals might be entirely rational, says Dr. Brunnermeier.
"You can sell off loans very easily in the market," he says. "If others continue to go on, then you can stay on. You try to forecast when the others are getting out. You don't focus on the fundamentals. You focus on the other players."
I continue to fail to understand how rational people can believe how slicing and dicing the cashflows does anything to change credit risk. This is the exactly same argument used in subprime in order to justify throwing underwriting standards out the window. As if CDOs/CLOs were the first time that anyone thought of the concept of diversifying credit risk.
Step 3: So what happens next?
Well the PE shops will do OK on their current investments, since the lenders are taking on most of the risk (convenant-lite loans, etc) though there will be a generation of exits that will be delayed as they will not be refinance-able during the credit downturn.
However, when credit dries up, the new mega-funds will be much harder pressed to outbid the public markets and the strategic buyers (which is the natural order of the universe) for new acquistions.
Investment velocity is a large driver of returns and one should expect this to return to much more normal levels...
Rubstein from Carlyle takes a thoughtful view here
One might say, this is not exactly the time to be buying BX.
Full WSJ article here