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Making a Play For the Dumb Money

By Steven Pearlstein
Wednesday, March 21, 2007

So the Blackstone Group, which grew rich preaching the advantages of being private, now wants to go public. If you needed any proof that the market has peaked, that the bubbles in private equity, hedge funds, real estate and credit derivatives are about to burst, this is surely it.

Don't fall for all those explanations about how Blackstone needs to raise capital or find a way to allow its visionary founders to cash out. Blackstone has a proven record of being able to raise all the private capital it needs. Pension plans and wealthy investors would line up around the block to purchase a piece of the firm.

No, the reason Blackstone is considering going public is simple: It's at market tops like this that dumb money will overpay. The smart money is getting out while it can.

What we're about to see is not a replay of the 2000 market bubble so much as it is of 1987, when another credit bubble triggered an earlier mania in corporate takeovers. Back then it was junk bonds, Drexel Burnham Lambert and Mike Milken's annual "predators' ball" in Beverly Hills. This time it is leveraged loans and credit default swaps, private equity and hedge funds, and Blackstone founder Steve Schwarzman's 60th birthday bash at the Park Avenue armory with Rod Stewart and Patti LaBelle.

In both cases, a small number of clever people used other people's money and creative financing to earn ridiculous sums relative to the risks they took and the real economic value they created. Eventually, they push things one step too far and the whole thing collapses. As in most cases where things look too good to last, they usually don't.

Don't take it from me. The smartest deal guy I know is Bill Conway, one of the founders of the Carlyle Group, Washington's own private-equity giant. And here's what he wrote in a Jan. 31 memo to Carlyle's dealmakers:

"[T]he 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. . . . 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."

He continues: "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. . . . And I know that the longer it lasts, the worse it will be when it ends." (For a PDF of the full memo, click here.)

Somehow I doubt that Conway's warning, or anything like it, is going to be part of Blackstone's road-show presentation when it starts to market its stock offering.

Buying public shares in an outfit like Blackstone is not the same as being a limited partner in one of its funds, like those pension funds, university endowments and rich families that have done so well in recent years. Under federal securities rules, those partnerships can be sold privately only to "sophisticated" investors. What can be offered to shareholders, on the other hand, is a stake in the company that manages the funds and earns fees and a share of profits.

The risks and rewards of being a limited partner, however, aren't likely to be much different than the risks and rewards of owning shares of the management companies. All of which calls into question the stepped-up efforts now being made by the Securities and Exchange Commission to ensure that unsophisticated investors are protected from the risks of hedge-fund and private-equity investing. In the real world of the marketplace, the distinctions between all these different types of investment vehicles are quickly blurring.

As I see it, the problem here isn't that an unwitting Joe Q. Public will put his entire 401(k) into Blackstone and lose everything. It's that by taking on public shareholders, funds like Blackstone and Fortress Investment Group will find themselves owing allegiance and loyalty to two sets of investors whose interests may not be well aligned -- may, indeed, directly conflict.

Investors will have very little insight into these potential conflicts. They will involve subtle decisions about which deals are done by which funds, how fees and performance bonuses are structured, or how much fund managers are allowed to invest in individual deals. Conflicts in tax-avoidance strategies are sure to crop up.

So far, the view taken by the SEC is that these conflicts can be managed by fully disclosing the risks to both sets of investors, along with enforcement of general fraud statutes. And as long as everyone continues to make lots of money, all that may be fine.

But the test will come when the market finally turns and deals begin to blow up. At that point, you can be pretty sure that fund managers will do everything they can to protect themselves and the interests of their limited partners and let the saps who are public shareholders take it on the chin.

So when Steve Schwarzman comes calling with an offer to sell you part of his stake in Blackstone Group, ask yourself: Are you being offered the chance to bet alongside him, or are you being suckered into betting against him?

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