Tuesday, May 29, 2007

What do sophisticated and unsophisticated investors have in common?

It is measured on different scales, but greed is the common thread that links the sub-prime mortgagee and the partner in a private equity firm.

The guy who buys a house he cannot afford hopes that the housing market will be one that is perpetually rising or at least until he can find a greater fool to whom to sell his house. The private equity partner is more sophisticated but he hopes that the market will rise faster than his indebtedness.

Some of these homeowners will make money, as will some of these partners. But those making the money are typically the ones who are among the early participants in a particular market. The world is not structured so that all market participants will always make money.

The question is what happens when money is no longer being made. The homeowner loses his house, the mortgagor is stuck with bad paper, the economy suffers. The private equity partner will probably not lose his home, but the suffering to the economy will likely be much worse. Look at what happened when Long Term failed in the late ‘90s. An indication that the private equity people are now getting nervous is the IPOs being issued by some of the players. If the future looks so great, why should they share it with the public?

As the sub-prime market has shady players (e.g., companies that don’t check a buyer’s earnings) so has the private equity market. In this case, the shady players are likely to be the managers of the companies being acquired. How many of these managers are more concerned with the shareholders than their own pockets?

One indication of the end of a market is the amount of media hype as to how great the market is. Google 'private equity' and see how many responses turn up.

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