Private Equity: NOT A Risk to Financial Stability

Forbes reported that the IMF has warned investors to pay attention to "areas of risk which could cause a disorderly correction in financial markets". First came a discussion of the carry trade in the Japanese yen that could have occurred at any time in the past decade with precisely the same arguments and exactly the same amount of evidence - none. Financial analysts at the IMF have noted the potential trouble emanating from Japan's ultra-low interest rates, but they aren't paying attention to the fact that the Japanese are also aware of the situation and are highly unlikely to wreck the global financial system since that would immediately destroy their own export dependent economy as well.

The new area of risk that the IMF wants investors to watch is private equity. The problem is that every time a buyout occurs, the acquired firm takes on a great deal of debt that could make the business more vulnerable to a downturn. While it is certainly true that taking on debt up to your eyeballs is a risky financial strategy, the greater reality is that not leveraging your business is itself a decision to hold back and retain your flexibility to ignore the needs of your customers. All businesses are going to end up taking on lots of debt before they go belly up, simply because they can. If companies already have a significant debt load, they can't slowly fade away over the course of decades. While it might be more psychologically satisfying to give everyone years and years to get used to the fact that a given company isn't producing any value, the economy is better off when resources flow to their most efficient uses.

At any rate, the geniuses behind private equity are constrained in their ability to take on excessive debt both by their bankers, who rightly fear default, and their own profit motive, because a failed company is never in the interest of its owner.

If this is the new risk facing the world economy, the next few years should witness some impressive growth.