The Toast Of The Town, Toasted.(Global Investor)(private equity)

PE returns have been spectacular, but getting them has required immense leverage in the form of high-yield debt.

Probably the most spectacular asset class of the late and lamented Great Bull Market was private equity (PE). All the big professional investors poured money into PE, for the same reason Willie Sutton gave. At his sentencing for armed robbery, the judge asked, "Mr. Sutton, why is it you always rob banks?" Sutton replied, "Judge, because banks are where the money is." Now, like Sutton, the private-equity pros are going to be punished for their sins.

The returns from PE have been spectacular. The consulting firm Cambridge Associates calculates that between 1986 and 2006, private equity had inflation-adjusted returns of 11.23 percent annually. At that rate, your money would grow 189 percent in 10 years. What endowment wouldn't be entranced by that kind of enhancement?

However, in order to get those returns, PE firms required immense leverage in the form of high-yield debt, and a friendly equity market. The formula was to identify a struggling company, acquire it using high-yield debt, improve the company operationally and then sell it back to the public via the stock market. Bear in mind that before they got respectable, PE firms used to be called LBOs, or leveraged-buyout firms, and high-yield debt was referred to as junk bonds.

PE firms used financial-engineering tricks, such as having the company sell a high-yield-bond issue and then using the proceeds to pay a special dividend to themselves, but that was a minor part of their business model. The high-yield-debt and IPO markets were the essential ingredients, and until the credit tsunami hit, there was huge appetite for both.

The situation now is that existing PE portfolios are stuffed with cyclical companies with leveraged balance sheets bought at prices based on formerly high earnings, which are not likely to return. This a lethal mixture in the sickest economy since the Great Depression.

There are puddles of blood on the floors of stock exchanges, so theoretically there should be PE opportunities. However, there is no financing available to acquire companies, much less to leverage acquired companies. The cost of high-yield debt, PE's currency, has skyrocketed. The average spread of high yield over Treasuries from 2003 to 2006 fluctuated between 300 and 500 basis points (bps), or 0.3 and 0.5 percent. Over the last 21 years it has averaged 535bps. Today it is 1,488bps, an astonishing figure in an industry that counts every hundredth of a percent. Since investors are terrified by the spreading economic weakness, new issues of junk bonds are almost impossible to place, and the debt-servicing burden would be so high it ...