It seems as if the more layers of the onion we peel back on the chaos in the capital markets the worse the news seems to be. I have long been a believer in the axiom “where there’s smoke, there’s fire,” and trust me when I tell you that the fire is far from being under control, much less extinguished. You see while most of the attention in the mainstream media has been focused on the debacle in the real estate and public markets, the next wave of failure is about to rear its ugly head. In today’s post I’ll share what I believe is the next segment of financial collapse set to rock the investment world…

Riddle me this…What conclusion should you draw from the simultaneous occurrence of a bear market, a recession, the virtual collapse of the investment banking industry as we know it, massive government bailouts, and the capital and credit crisis? The answer: Big trouble in the Private Equity markets.  News Flash…private investments are inexorably linked to public markets, and we’re on the brink of watching private equity firms suffer the same fate of their public counterparts. The problem is this…many private equity firms have yet to write down their investments and are still carrying them at book value, which can mean only one thing…they are significantly overvalued.

Think about it…private equity markets were perhaps even more frothy than the public markets the past few years. Massive amounts of deals were being done at very aggressive valuations that just won’t hold-up in today’s economy. Try this analysis on for size…take a random sampling of PE deals closed in 2005 and 2006 and look at their original valuations. Then revalue those some companies by marking them to current market conditions. The big sucking sound that follows is  the painful realization of equity erosion. Does this sound familiar?

The real shame is that the same short-term greed mongering that affected the public markets is about to rear it’s head on the private side of the table. Remember that PE investments are high risk investments, yet the big players in this market are institutional investors who simply got greedy and took on more risk than they should have. Again, does this sound familiar? It only gets worse…not only has the door been slammed on the public exit for many PE investments changing the landscape dramatically, but PE investors are likely going to be hit with big capital calls that can’t or won’t be met. This simply means a sell-off of PE investments at deep discounts is impending.

Even if you can’t connect the dots based upon recent adjustments in valuations in the real estate and public markets, just roll back the clock and revisit the evisceration of the paper wealth that occurred during the dot.com era when the bubble burst on frivolous valuations at that time. The moral of the story is this…don’t be at all surprised when the bottom falls out of the private equity markets…

 

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