A former student has forwarded to me a memorandum from William E. Conway, Jr., a founding partner and managing director of the Carlyle Group and chairman of Carlyle's investment committee, to all Carlyle investment professionals worldwide.
Some excerpts of Mr. Conway's memorandum follow:
>"As you all know (I hope), the fabulous profits that we have been able to generate for our limited partners are not solely a function of our investment genius, but have resulted in large part from a great market and the availability of enormous amounts of cheap debt. This cheap debt has been available for almost all maturities, most industries, infrastructure, real estate, and at all levels of the capital structure. Frankly, there is so much liquidity in the world financial system, that lenders (even “our” lenders) are making very risky credit decisions. This debt has enabled us to do transactions that were previously unimaginable (e.g., Hertz, Kinder Morgan, Nielsen, Freescale), and has resulted in (generally) higher exit multiples than entry multiples.
>"I EXPECT THAT THIS EXCESS LIQUIDITY, LEADING TO HUGE AMOUNTS OF
RELATIVELY CHEAP FINANCING, WILL CONTINUE FOR AT LEAST THE NEXT 12-24
MONTHS. FRANKLY, I SEE NO CATALYST THAT WILL LEAD TO A QUICK, LARGE OR DRAMATIC CHANGE IN THE GLOBAL LIQUIDITY. HOWEVER, I HOPE THAT YOU
HAVE NOTICED THE ROUGHLY 40-50 BASIS POINT MOVE UPWARD IN THE YIELD
CURVE OVER THE LAST 45 DAYS. THIS IS A BIG MOVE IN A SHORT PERIOD OF TIME AND IS PROBABLY A RESULT OF MARKET RECOGNITION THAT THE FED WILL NOT BE REDUCING RATES ANYTIME SOON.
>"I know that this liquidity environment cannot go on forever. I know that the longer it lasts the more money our investors (and we) will make. I know that the longer it lasts, the greater the pressures will be on all of us to take advantage of this liquidity. And I know that the longer it lasts, the worse it will be when it ends. And of course when it ends the buying opportunity will be a once in a lifetime chance. But, I do not know when it will end.
>"If you thought the liquidity were going to end tomorrow, you wouldn’t do any deals today. But, of course, you don’t think that it is going to end tomorrow. Most of us think, and act, like tomorrow will be just like today and yesterday and the day before that. And probably it will be.
>"As an aside, what is causing this global liquidity? There can be no doubt that the liquidity is global. Look at the US, Europe, China, Russia, the oil producing countries. Is the liquidity due to a shortage of investment opportunities? Is it due to U.S. financial policies (e.g., the trade deficit)? Is it due to the rise of China and India with their giant pools of skilled labor? Is it due to energy prices? The forward progress of technology?
>"And, as a further aside, what might cause this liquidity to end? A terrorist attack? $100 per barrel oil? Trade protectionism? The absorption of excess skilled labor into the global economy? The U.S. elections? Russian energy policies? A multibillion dollar bankruptcy? A tightening by the Bank of Japan or the U.S. Federal Reserve? The passage of time? I wish I knew.
>"A consequence of the enormous liquidity will be lower IRR’s on many of our investments. Perhaps our limited partners will be very satisfied with lower IRR’s, because even at reduced levels, these returns should still far exceed their investment alternatives.
>"SO WHAT DO I WANT YOU TO DO?
>"First of all, I have asked myself what I would do if the excess liquidity ended tomorrow. Certainly I would want as much flexibility as possible –– are our covenants loose enough? Have we hedged against a sharp upward move in rates? Can we draw down on our revolving credit loan facilities? Would we be glad we recapped the company when we did or would we reject the resulting financial straightjacket? While each situation is unique, you ought to be thinking about financial flexibility.
>"Secondly, the global liquidity has led to a significant reduction in risk premia –– most investors in most asset classes are not being paid for the risk being taken. OUR STRATEGY SHOULD EVOLVE TO TAKE LOWER RISK DEALS AND EARN LOWER RETURNS, RATHER THAN HIGHER RISK DEALS AT ONLY SMALL INCREMENTALLY HIGHER RETURNS. Even though it is capitalized, let me repeat –– lower IRR’s with lower risk, NOT lower IRR’s at the same risk. A short run consequence of this strategy is that investors in private equity measure only return (“Are you in the top quartile?”) and not risk. On a related point, for modeling
purposes, we should generally look at shrinking exit multiples (vs. entry multiples). Another related point is that we should look for as much of the return as possible to come from debt paydown, rather than exit value.
>"Thirdly, we should redouble our focus on deals with downside protection –– asset coverage, multiple and early exit paths, strategic partners, the aforementioned debt paydown, government protection, consumer needs (coffee and a donut?), controllable capital expenditures, defensible market positions, etc.
>"Finally, use our firmwide resources to do better deals and to help out when everything doesn’t go as planned. Examples of these resources are One Carlyle, the global network, industry specialists, senior advisors, bank relationships, real estate, and high yield expertise.
>"Last year, I asked you to be humble, ethical and optimistic. This year I am asking you to be careful as well."
Howard Katz has been making similar points without Mr. Conway's kid gloves for quite some time.
Mr. Conway is disingenuous. The liquidity in the world economy is due to the policies of the Fed and other central banks. Where else would the liquidity come from? All previous central bank monetary expansions have led to inflation. It will be a big surprise if this one leads elsewhere.
Interest rates are important to Carlyle, a private equity firm, not just because of the rate that they pay when they borrow. A more important reason is the valuation of the assets that they purchase and resell. Low interest rates increase the present value of earnings, raising stock market valuations. If Carlyle can increase net after-tax earnings by rearranging a firm's financing, low interest rates magnify the future value of the increase in net income, resulting in a large profit for them. Should interest rates rise, financial adjustments (e.g., substituting debt for equity) will not have as big an impact on the net present value of earnings, reducing the returns to their fund.
As Howard Katz has argued, it is a tragedy that wealthy special interests such as the Carlyle Group have been able to extract large financial rents due to Fed policy that will play themselves out in the larger economy as an inflationary tax on all Americans.
What Mr. Conway does not mention in his memo is:
1. The low interest rates and resultant international liquidity are a direct result of Fed policy
2. The same low interest rates, liquidity and Fed policy will result in inflation
3. Hence, Carlyle group has benefited at the expense of all those who will pay higher prices in the future.
As Frank Zappa and The Mothers of Invention put it in "Absolutely Free":
"Don't try to do no thinkin'
Just go on with your drinkin'
Just have your fun you old sun of a gun
And drive home in your Lincoln"
What can the small investor do? (1) Keep holdings in stocks and bonds to a minimum; (2) commodity and gold investments should be at least a portion or your portfolio.
My stock broker responds:
"I think there are some good points in this message-The Hedge fund industry will have its day of reckoning when the carry trade ends - I am very skeptical of investments that do not offer liquidity like hedge funds. I have clients who think they are invested in treasuries and making 15% a year in currrency hedge funds they were sold at the the country club - they think they are conservative - I have spent hours trying to convince them no more then 10% of weath in these illiquid investments. The Hedge fund investors will be the ones to get hit when the rates move to fight inflation. There only one problem no one knows the exact date. Remember if you miss the 5 biggest up days in the market in a year it can be most of the return for that year. Everyone has opinions - just turn on CNBC but like the letter says many events can change the course instantly. If history repeats itself and earnings drive stocks in the long run this market has some legs-with some hicups along the way."
corruption
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