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Calculational Chaos: What the Salle Mae Deal Tells Us About Private Equity & Government Regulation

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Today’s buyout of student loan lending kind Sallie Mae sheds light on one of the most stubborn mysteries in finance: source of private equity success.
Like hedge fund managers, the heads of private equity firms have become fantastically wealthy in recent years. And as private equity firms sell equity into the capital markets, the private equity guys stand to become even wealthier. One magazine recently pronounced Blackstone Group founder Steve Schwarzman the “king of finance.”
But why are these guys making so much money? The simplest reason is that they have demonstrated a knack for buying companies from public shareholders, holding them for a few years and then selling them back to the capital markets for much more than they paid. Exactly how this increase in value is accomplished is the real puzzle. Some folks regard this as something of a scandal—the shareholders who sold out to the private equity firms must have been cheated, they reason. In this view, the value realized by private equity is simply value expropriated or alientated from the public shareholder.
Others regard it as almost miraculous. Or at least magical. The usually erudite Michael Lewis once described the process by which private equity firms increase the value of their portfolio companies as “Abracadabra.”
But magic isn’t a very satisfactory answer. Despite talk of dealmaking as an “out of body experience” from some private equity big-wigs, they aren’t pulling value out of the astral plane. Often what they are doing is discovering sources of market ignorance—situations or events that make it more difficult to understand a company’s value—and attempting to overcome that ignorance. While the variety of firms and personalities involved in private equity make it dangerous to speak in generalities, what many private equity firms specialize is the identification of companies subject to unusual concentrations of market ignorance and the acquisition of information that gives rise to a unique appreciation of a company’s value.
We can see this in the Sallie Mae deal. The student loan business is heavily regulated by the government, and those regulations create a kind of calculational chaos that makes it difficult to determine or realize the value of the company. The banks and private equity firms involved in the buyout of Sallie Mae identified the regulations as a source of market ignorance and overcame that ignorance by closely studying the opportunities of the company.
Government regulations are just one source of market ignorance. There are many others, and private equity firms are growing increasingly sophisticated at identifying them. But what’s important to realize about this activity is that it begins with this identification of ignorance—figuring out what is not widely known. And once a source of the ignorance is identified, it opens up new sectors for private equity.
The key to this idea is that that the source of private equity success is not because private equity guys smarter than everyone else. The key is that they are acquiring knowledge of our ignorance. Private equity isn’t magic. It’s philosophy.
Earlier: Levering Up: What The Sallie Mae Deal Tells Us About The Financial Sector [DealBreaker]