Is Fund Size Leading to Perverse Decision-Making?

The $7 billion TPG-led recapitalization of Washington Mutual. The $5-8 billion Corsair-led syndicate to support the ailing National City. The tens of billions invested by sovereign wealth funds (SWFs) in Citigroup, Merrill Lynch, Morgan Stanley and UBS. These are stunning numbers for firms that are in a lot of trouble. Now being a contrarian, I applaud the guts-of-steel necessary to invest in the face of financial panic. The problem is, I just don't see the panic reflected in the U.S. stock market, notwithstanding all the issues with the global credit markets. And I know that these private equity firms and the SWFs say that they are getting quality assets on the cheap. But I worry about the conflict between the ability and desire to write a big check and the best time to write such a check.

Because it seems to me that some funds are a little trigger-happy, pushing money out the door while they can in order to justify their existence and to spend time managing dollars instead of deploying them. And if I am right, this is a very worrisome trend, indeed.

Mega-funds, be they of the hedge, private equity or SWF variety, face pressures of scale. It is necessarily difficult to invest such massive sums, and it takes incomprehensible amounts of discipline to let ok deals (from a risk/return perspective) go by in order to wait for the truly great deals with solid margins of safety to present themselves.  Because it can get pretty embarrassing sitting on $10 billion (or in the case of SWFs, $100 billion or more) of commitments, getting paid management fees and not putting money to work. There is a natural pressure to pull the trigger, because it may be more painful waiting for the right deal to come along than doing a deal that ends up being mediocre but being busy in the process. And it certainly is impossible to raise a fund V, VIII or XII if one can't even get past 50% of committed capital for the current fund. This would bring the whole asset gathering operation to a screeching halt. And we can't have that, can we?

Why am I picking on these deals? Because the dollars are so large and the sector being mined so troubled. I get the argument about the value of WaMu and NatCity's core deposits and branch networks; I was once a Financial Institutions M&A specialist and spent lots of time looking at such things. But so much of the value of these deals turns on asset side of the balance sheet and the massive mortgage and commercial lending books. In my opinion we are early in the credit down-cycle, and even if one doesn't agree with my assessment, I think it is hard to argue that things will be rosy any time soon. And further, there is much uncertainty about the depth, breadth and timing of the credit downturn. With all of these unknowns, clearly the investors in these deals are looking at the price they're paying and saying "This is my margin of safety; I'm buying cheap." But does anyone really have enough information yet to make such an assessment? Is buying at a 30% discount to market the right number? Is fair value really 20%? Or is it 50%? I certainly don't know. Maybe they do, and they could be right. But the risk/reward calculus seems kind of skewed at the present time.

If the deal sizes weren't so large I'm not sure I'd raise my eyebrows quite as high. It's just that the pressures of size are so great that I can see it adversely impacting rational decision-making. I'll be keeping careful watch on these deals. And I'll be interested to see the next series of mega-ticket deals getting  done for exactly the same reasons.

Comments

[Yaser Anwar]

Besides the issue you highlight of collecting mgmt fees and looking busy, I think a lot of these funds are looking at precedents too where either a PE or SWF made a killing on such deals most notably Apollo in the S&L crisis and Prince Al-Waleed with Citi. The problem with this is the current situation is worse than in the 1990s or on average the previous ones.

The US economy is dramatically more leveraged with bank credit alone at 65% of GDP, up from about 47% of GDP in '90. Additionally, housing prices are falling more broadly and more rapidly going into this recession than in '90, increasing the magnitude of write-downs and eroding consumer spending.

That said, I do think these PE/HF/SWF firms are made privy to a lot more info, in this case I suppose balance sheet/P&Ls, than a typical shareholder given they buy stakes upwards of 3-5% (right?). Also, I think these funds would much rather live with the stigma of having lost money vs. having had money and stayed on the side lines.

I'm probably a bit too early in saying this, but so far it's not working out too well i.e. Citadel/E-trade, China's investment in BX, which has caused these firms to start buying up a small % of big commodity exposed companies (most notably stakes in Total and BHP)

What I've noticed is, and am sure many have too, is that most of the buying of these large stakes has not been by hedge funds, but PE/SWFs because of their typical exit cycle 3-4 years down the line vs. HF fighting to be alive for another year (in this environment probably a quarter!).

A good company I've been buying is FTI Consulting and would recommend reading their conference call transcripts and occasionally their website which shares their views, on the markets because FTI's primary goal is helping companies restructure and recap during economic downturns (or especially during them).