You've heard of the Greenspan Put, right? The theory was that when Alan Greenspan was the chairman of the Federal Reserve, if anything bad happened to the economy (and hence the stock market), Greenspan would bail investors out by dropping interest rates, the same way a put option hedges against a falling portfolio. As I watch today's stock market make an Icarus-like climb upward, I wonder if the Greenspan Put has been replaced with the Blackstone Put.
What I mean by that is, virtually every day, another huge firm gets bought out by a private equity firm. Sallie Mae
As a result, it seems as if private equity activity has not only created a floor for stock prices, but also helped drive it to new heights.
There's only one problem with this sequence of events: The private equity party could turn on a dime. PE firms are making fistfuls and fistfuls of cash because they can raise enormous amounts of money and borrow at ultra-low interest rates and extremely lax terms. As a result, they can bag bigger and bigger elephants, and because the debt market is so accommodating, it almost ensures those private equity firms will make money.
You see, according to my understanding, private equity firms make the bulk of their money arbitraging the difference between a company's return on capital and its after-tax cost of debt. It's kind of like buying a house -- if you can buy a house, rent it out, and pay off the mortgage and other costs with the rental income, you are pretty much arbitraging the cost of debt (the mortgage rate) versus the return on capital employed.
Private equity companies do the same thing, except instead of buying houses with a ton of debt, they buy entire companies. Their returns are better because they can add value through hiring better management, and also because there are only a handful of firms with the clout, financial wherewithal, and expertise -- as well as the, shall we say, cojones -- to make these billion-dollar bets. On the other hand, pretty much anyone can get a mortgage and bid on a house, which drives returns lower.
However, trees don't grow like Jack's beanstalk, and there are a lot of events that could cause the Private Equity Put to expire out of the money:
Interest rates go up
Interest rates are pretty low by historical standards. This benefits PE firms in myriad ways. First and foremost, it lowers their cost of debt, which means their hurdle rates for target acquisitions are lower. In a nutshell, if someone gave you a billion dollars and only asked for a 1% interest rate payment, you could buy almost anything and make money. If they asked for a 10% rate, then you'd be much more limited in what you could do with the money and still make a profit after paying 10% on that debt.
What could cause interest rates to go up? Bondholders hate inflation because it causes their future coupon payments to be worth less. So if inflation increases, interest rates usually go up with it. Interest rates are also low in the U.S. because the rest of the world, primarily Asia and the Middle East, has had a voracious appetite for U.S. government debt thanks to those regions' booming economies -- if this changes, then the cost of debt will go up.
Credit risk premiums increase
What is the price of risk? You pay auto insurance to eliminate the financial risk of getting into a car accident. When a PE firm buys a company, it has to pay a risk premium because the company becomes much more financially unstable with the debt piled on.
However, PE firms lately haven't had to pay much in credit risk premiums because there are a lot of investors, banks, and hedge funds willing to make loans to PE firms (also known as leveraged loans). However, this could change on a dime if any of those loans go under. It's very likely that when the first high-profile PE-backed company goes under, credit risk premiums will widen considerably as investors get skittish.
PE returns sour
PE returns have soared, so investors climb all over themselves to give them more money. As more and more PE firms raise multibillion-dollar funds, the competition becomes fiercer to put the money to work, which drives up acquisition prices and drives down returns. If the returns fall too low, then many institutional investors will probably stop giving PE firms so much money.
How to play it
I'm hardly alone in thinking that many different things could cause the "PE Put" to go away, which could bode poorly for the stock market. As a result, it's hard for me to be enthusiastic as I watch the stock market head higher on a one-way street. However, if I'm patient, I think I can buy stocks at a cheaper price if the "private equity put" expires.
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Fool contributor Emil Lee is an analyst and a disciple of value investing. He doesn't own shares in any of the companies mentioned above. Emil appreciates your comments, concerns, and complaints. The Motley Fool has a disclosure policy.