Blackstone went public Friday, were you can buy shares that give you a right to cashflow from a blackbox where the insiders clearly know how to maximize their returns. Scary.

The problem with business cycles is that they are cyclical but nonpredictable, which seems a paradox, but it's one of those things were with hindsight the past is very predictable, but not so much in real time. My old boss used to say back in the the 80's it was HLTs (Highly Levered Transactions) that were the hot new financial vehicle that ultimately blew up, and in the 90's they just renamed the beasts: air-ball finance, so-called because collateral was an 'air ball' of zero tangible worth (there were other synonyms for different areas). And of course after being embarrassed for not getting in early, we got in late and got creamed in the late 90's.

So I'm amused by this cycle's unique object of exhuberance, which I think is 'private equity'. The key with these deals is they take public companies private, or simply take over other private companies. But run from a hedge fund, with a 3 year commitment, if you give me $5B I get 2% of assets ($100mm) a year w/o producing any profit, and generally these things are run by a handful of principals so that's real money to the decision makers. And because their portfolio consists of 'turn around' stories, investors don't even expect positive cash flow in the underlying assets, and meanwhile nothing is marked to market.

There is a cost/benefit with mark to market. Keynes' famously said that farmers would not ever plant if they could take the market value of their crops every second like on any exchange, and that a little 'sand in the gears' might be helpful so investors would no be so skittish. Certainly, like judging truth by popularity, you don't want to pay too much attention to market values. But as with most things, moderation is key. They other side of marking everything to market is marking nothing to market, which allows a crappy business model or portfolio manager to destroy value for a long time. Further, a losing portfolio manager might no he is in trouble and take a large risk knowing that 1) if he win he wins big and 2) if he loses and losing big and losing a little generate the same payoff. Heads he is up hundreds of millions, tails only tens of millions (the 2% of assets). This is a recipe for disaster, the essence of moral hazard.

I have seen a lot of private equity funds started by guys who's only experience is being part of a team that made a lot of money. It is very hard to know if these people have alpha, because for many, they were just in the right place at the right time (eg, just because he worked at Goldman doesn't mean he can make Goldmanesque returns).

I suspect that the end of this business cycle will be precipitated by a conspicuous failure of a private equity firm, which will then cause a reconsideration of all private equity funds, they won't be able to sell their crappy assets to each other and the game will up (like when the United deal fell apart in October 1989, signalling the end of the junk bond market).