The Hottest Game in the Big Casino is Private Equity

Them that has, gets. Barron's cover story this week - "Rich Man, Poor Man" - illustrates our theme.

The top 1% of the United States now has 190 times the wealth of the median American. This ratio has shot up from 131-to-1 in 1983. The core reason is the 'new inflation' over the last 20 years that has gone into financial assets, not into consumer prices. The easy money makes it possible for a group of investors to buy a business they don't really understand, with money they don't really have, at a price that is probably more than it is really worth.

The Feds, in their infinite wisdom, no longer report the number for M3, the U.S. money supply. Adrian van Eck, however, guesses that it is increasing at about a 10% rate. He figures that $1 trillion of additional 'money' will be put into the financial system in 2007 alone.

This is also why the people who control access to money - the people who run financial firms - are making so much of it. Goldman Sachs (NYSE: GS), for example, has never been more profitable.

That is also why the hottest game in the big casino is private equity.

We give you a personal example. An old friend of ours just announced that he sold his business, which he had started from his home about 35 years ago with almost no financial backing - a genuine American entrepreneurial success.

Now in his 60s, what was our friend to do? He might have run it for another 10 years or so himself... he might have passed it on to his family. Instead, he sold out - for $140 million.

To whom did he sell? Someone in the same business? Another entrepreneur?

Nope. He sold to a group of investors, who, as near as we can tell, have little actual experience in his industry.

This, is how the financial world works now. Our friend was a rich man before he sold. Now he is very rich... and his business has become "financialized." Now it is a financial asset, ready to be sliced, diced, repackaged, loaded up with debt, leveraged, derivatized, securitized and traded in the public markets as though it were a Jackson Pollock painting at an auction for blind people.

Let's imagine that the company made $10 million last year. But, now - when the IPO comes out - it will probably reach a market capitalization of over $200 million. Dow stocks are trading at an average PE of 21; even at $200 million, the stock would be a bargain. The CEO and top executives would have stock options. And the venture capitalists... and the investment bankers and Wall Street strategists and financiers... would all get a piece.

And where did the investment group get the money to buy the firm? They probably borrowed it, so there was money made there... and made again when it was refinanced... and then again, when the refinanced debt was packaged into derivatives... against which swaps were bought and sold.

The whole thing makes our poor head spin. Upon this one company... this one stream of income... a whole industry of money shufflers can go to work.

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