Lots of Dollars, Little Sense

By Steven Pearlstein
Wednesday, September 6, 2006

Call me dense, but I'm having an awfully hard time understanding the investment world these days.

For reasons that aren't exactly clear, the supposedly smart people with all the money -- pension funds, university endowments and wealthy investors -- have decided it no longer makes sense for them to look for undervalued public companies, or promising new companies looking to go public. Instead, they prefer to put their money into private equity funds, which charge outrageous fees to look for undervalued public companies, or promising new companies looking to go public, and buy them up at a price 20 percent higher than the current stock-market price.

Of course, buying whole companies can get expensive, especially when you're talking about an energy giant such as Morgan Kinder or HCA, the country's largest hospital chain, just to give two recent examples. So to finance the deals, private equity managers have their newly acquired company issue lots of junk bonds, at high interest rates. These bonds are then bought by hedge funds, which also charge outrageous fees and also raise most of their money from pension funds, university endowments and wealthy individuals.

In a few instances, private equity funds have also begun to raise capital by issuing common stock, which also tends to be snatched up by the very same hedge funds, pension funds, university endowments and wealthy individuals.

And to top things off, the new owners invariably offer fat new pay packages to the managers of the company they've just acquired -- in most cases, the same managers who were running the company when it was public. The idea is to give them even greater incentive to maximize the value of the company, so it can be taken public again.

Now, if this sounds to you like a giant, circular Ponzi scheme, it's only because it is. As far as I can figure out, the winners will be the fund managers and their highly paid enablers, the investment bankers. And let's not forget the corporate managers, who have the chance to become fabulously wealthy if they are successful in stealing the company from public shareholders to whom they presumably owed a fiduciary duty, and later selling it back to public shareholders at a higher price.

This new arrangement raises serious questions about the efficiency of our vaunted capital markets.

After all, if these public companies are such a bargain, why don't the pension funds and wealthy investors just buy their stock instead of relying on overpaid intermediaries?

And if loading up companies with lots of debt is a good thing to do for equity holders, why don't more public companies do it before the private equity guys show up at the door?

Come to think of it, if giving corporate executives even bigger pay packages gives them the incentive to generate better long-term returns for investors, why don't public companies do it before the private equity guys show up?

There are two possibilities here.

One is that the stock market is temporarily -- and irrationally -- undervaluing public companies, providing easy arbitrage opportunities for private equity and hedge fund managers.


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