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Excess Cash, Complacency -- Not So Perfect Together?
An excess of cash and complacency characterizes elements of today's financial markets: excess cash, in the form of the seemingly endless gush of money that continues to flow from institutional investors through private equity investors and into private equity deals; and excess complacency, reflected in the lowest risk premiums that the market has ever seen.
These two excesses have created the conditions for a sharp increase in the number of private equity firms and hedge funds, an explosion in the demand for private equity deals and a torrent of cash coursing through the veins of the financial markets.
In a round-about and only slightly serious way, we can "blame" this state of affairs on David Swensen, the investment legend who, as head of the Yale Endowment, has beaten the pants off his competitors -- other college endowments -- by pioneering the use of private equity and hedge funds in the formerly staid and conservative culture of the university endowment world.
Since Swensen took over as head of the Yale Endowment in 1985, other investment professionals at universities like Princeton and Columbia have watched with amazement and chagrin as Yale's endowment earned an annualized return of 16 percent over the past 21 years, leaving all other Ivy League investment professionals in the dust. Yale's endowment ballooned to $18 billion.
Not only college endowments, but other institutional investors took notice as well: state governments, municipalities and other nonprofits. Soon, the money poured into alternative investments, as everyone tried to emulate the Swensen model.
Cash poured from endowments like Harvard into firms like Henry Kravis' KKR and the countless other private equity firms that, like hedge funds, have sprouted up like flowers (or weeds, depending on your perspective) in response to the increased demand.
Cash on the Line
Now, these private equity firms can't just sit on this cash; they have to put it to use -- that's why they were given the money in the first place. By happy coincidence, as the money was flowing into their firm, these private equity firms were blessed with a third excess: the sudden increase in risk aversion among corporate executives as a result of the recession of 2000-02 and the terrorist attacks of Sept. 11.
Simply put, businesses stopped spending and loaded up their balance sheets with cash.
So, armed with excess cash, the new chiefs of Wall Street sought out as targets companies with excess cash, and they had no trouble finding them. An excess of cash on the corporate balance sheets of America, a new appetite for junk bonds, and rapacious institutional investors seeking higher returns provided the elements for private equity to flourish.
This phenomenon has played out in ways that affect even us, the small-time investor. Curious as to why your small-cap and mid-cap stock fund has done so well recently? At least part of the answer lies in all this cash churning through private equity firms.
With so much money -- and fewer and fewer deals -- the private equity investors looked down market, and started buying up smaller firms. The age of the RJR Nabisco deals was being eclipsed by the gobbling up of small- and mid-cap firms.
As in any part of the financial world, when too much money starts chasing too few deals, you can expect, at some point, a correction to occur. Of course, nobody knows when, and nobody knows how it will play out.
Cause and effect, you see, is difficult to figure out in a world as complex as this one.
When -- or if -- the correction comes, and large-cap starts to outpace small-cap, how severe will the correction be? And will it affect other parts of the markets and the economy?
The difficulty inherent in sorting out cause and effect, both in explaining the past and predicting the future, can also be seen in the disagreement as to whether the weakness in the housing markets will affect consumer spending in a dramatic way.
Whether or not the economy is a house of cards or a castle of concrete, well, we'll find out eventually. But we can say that all the money floating through the financial system can't continue forever.
Fred D. Snitzer is chief operating officer in the investment-management firm of Prudent Management Associates, specializing in high-net-worth and tax-deferred asset management.