"The energy, mining services and financial services sectors will soon appear on private equity's radar as sharemarket turbulence drives down prices, according to a leveraged buy-out consultant. Ernst & Young private equity leader Bryan Zekulich says sectors that have historically had low levels of private equity involvement are now more likely to be sized up."

The Pirates headed for port last August when the credit storm started blowing. Doing deals with borrowed money got a lot harder last year. But this year, some of the private equity firms are doing deals with cash. And unlike last year, the market is full of good companies with not-so-good share prices.

"We expect to see PE [private equity] take advantage of good buying opportunities created in the current economic uncertainty - basically sound but temporarily distressed assets that investors have lost faith in, but these opportunities have the potential to yield high long-term value," he said.

Much to our chagrin as a share tipper, the junior miners and small caps have been absolutely smashed so far this year. But it's interesting to note that cashed-up players are starting to kick around the small cap and resource rubble. They're looking for something that can be salvaged, picked up, dusted off, and sold off down the track for a gain.

But what exactly are the private equity firms looking for? In the resource sector, Al Robinson over at Diggers and Drillers tells us to look for the three Ps-people, projects, and prospects. "Good people don't usually get involved in bad projects," Al says. "Most of the time in markets, it pays to follow the money. But with the miners, you follow the people."

"But I reckon what the pirates are after are good projects they can buy at a discount. With commodities prices doing a major correction and taking share prices with them, it's going to leave some amazing projects really vulnerable to opportunistic players. I'm watching for takeovers...and I don't really care who's doing the taking over. As long as we're in good projects, we should do alright."

While the pirates or private equity are hunting the juniors for booty, the indexes will probably follow Wall Street's Friday lead and head up. The Dow finished Friday up over 300 points. Oil fell another four percent to US$115. All this despite another multi-billion dollar loss by Fannie Mae.

It's amazing how markets can sometimes defy the news cycle. But it's generally wise not to second guess the market-unless the market is totally rigged (which is hard to prove, although watching the S&P futures is a good place to look for this sort of thing). Still, it's as if the market is cheerfully convinced that as bad as things are, they can't get much worse.

But they did get worse this weekend. We just don't know how much worse yet. We ended last week's Daily Reckoning with some thoughts on how long the current crisis in central banking could last. We wrote that, "Here we are eighty years later dealing with the same problem. How will it end this time? Which will come first, the Depression, or the War?"

Notch a victory for "war." It's hard to tell exactly what's going on in Georgia at the moment. Without going into too much geopolitical detail, the Russians have invaded a disputed area in Georgia and are having their way with the tiny country.

But what if they held a war in a vital energy corridor between the oil rich Caspian Sea and the West…and the oil price did nothing? That's what it looks like so far. The only non-Russian oil and gas pipelines from the Caucasus to the West go through Georgia. There is clearly an energy angle to this latest conflict, whether or not it is what lit the fuse to the whole thing.

More on this subject tomorrow, with some detail. For now, we should point out how confusing a time it is for the Nation State as an institution. It is getting both stronger and weaker at the same time, depending on where you find it and how it generates revenues (taxation or resources).

In the West, you have governments gradually going bankrupt as their populations age and they devote more and more of their resources to health and pension promises they will not be able to keep without much higher levels of taxation. These institutions simply can't meet the needs of their people any longer, and sooner or later, that failure will be obvious.

Meanwhile, authoritarian capitalism (saw the term in the paper last week and liked it) is on display in both Russia and China. In Russia, energy profits power the resurgent state. In China, the government is putting on a show for the world: here's what a command economy with lots of energy can produce.

It sure was a gorgeous opening ceremony, though. Say what you will about the current Chinese government. But let's not forget Chinese culture is over 5,000 years old. As destructive as it is to the human spirit, not even communism can ruin that much tradition. Beijing looked fantastic on Friday. It's too bad the rest of the world seems to be on fire.

Dan Denning
The Daily Reckoning Australia

• One of the Biggest Humbugs in Capitalism is Private Equity
• Price of Oil May Rise Due to Scale of Georgian Conflict
• Red Bear Rising: Russia’s Resource Based Geopolitical Strategy
• Rumours Swirl Over Chinese Equity Stake in BHP Billiton
• Australia’s Response to the U.S. Bailout Plan

The idea of private equity is that a group of smart, well-financed, slick operators can get the better of the chumps in the public markets. The idea is probably right, but it makes nonsense of the whole premise of modern market theory - that the markets always know more than any individual or group of players. If the markets put a price of $100 on a stock - that's what it is worth, no more, no less; at least, that's the theory.

But the private equity hustlers nevertheless go into the public market, buy a company at a price set by the market, clean it up, cut it up, and then sell it back to the market at a higher price.

Supposedly, the private equity boys have "added value" by nipping and tucking on the corporate body before selling it back to the yahoos. But what do the financiers know about running a company? How is it possible that they are able to take a company out of the control of the people who know it best - founders, CEOs, managers - and improve it? And even if they were to get lucky with one, what makes these dilettantes think they can do it 160 times - which is the number of buyouts completed by KKR? We don't recall the details, but we remember a study showing that private equity surgeons had added no net value to the companies they sliced up...and that share prices tended to sink after the initial return to the market.

And then you have to wonder about the chutzpah of it. Public shareholders were getting smacked both coming and going - once when they sold a company to KKR for too little...and again when they bought it back for too much. And now cometh KKR into the public markets to smack the poor lumpeninvestoriat again. This time, KKR says, in effect: we're smarter than you are...but we're going to let you buy our shares anyway. Of course, if KKR really were smarter, why would they want to cut the little guys in? If they could reliably add value and produce above-market gains they could raise all the capital they could possibly need. Of course...they can't. And now, with the chumps wising up, it's getting harder for private equity players to raise money.

Nor is this the first time KKR has sold shares to the public. The IHT reports:

"KKR Private Equity Investors had its debut on the Amsterdam bourse at $25 on May 3, 2006, when KKR sold 200 million shares of the unit, valuing it at $5 billion. The shares have fallen more than 57% since then, to close Friday at $10.50."

Bill Bonner
for The Daily Reckoning Australia

• Pirates of Private Equity Flying Colours Off Australia’s Shores
• Rumours Swirl Over Chinese Equity Stake in BHP Billiton
• Negative Equity Becoming the Norm in U.S.A.
• One Year Treasury Bills to be Reissued by Bush Administration
• Globalization is No Longer a Force for Good

"The leading players in the greatest credit expansion of all time were the financial companies," we explained to Elizabeth on our way back from Geneva. "They were the debt mongers. They made their money by leveraging up the entire world - from people living in trailers on the outskirts of a godforsaken town in the middle of nowhere... to the masters of the universe themselves in Manhattan and London. Now that the world is de-leveraging itself, it's only natural that the financial industry takes the biggest hits."

Yesterday morning alone, Fannie Mae and Freddie Mac - who played a starring role in the leveraging spectacle - saw their own stock marked down. The companies lost some $4.5 billion worth of capitalisation before lunch was served.

And you remember Blackstone? The private buyout firm was so much in demand during the boom times that even its founders decided it was time to sell - to the public. You may recall; we were suspicious. The idea of Private Equity was that the hotshots could outsmart the public markets. It was an idea completely at odds with Modern Portfolio Theory, which holds that price movements are random; therefore it isn't possible for a Private Equity firm to beat the public markets for long. If they seemed to do so, it was just, well, a fluke.

MPT was always a fraud, but it more than a little cheeky on the part of Blackstone to pretend that it could beat the public markets while at the same time becoming part of them. If they could really outperform the public markets, we wondered, why would owners ever want to sell? What could they do with the money? And if someone who actually could outsmart the public markets offered to sell you a piece of his business... shouldn't you be a bit suspicious? Unless you've got some pretty racy photos that you're planning to show to his wife, it makes no sense. Obviously, the seller has a better idea of what he's unloading than the buyer does of what he is getting - especially if he's such a great judge of investment value. Wouldn't it be like challenging a world master to a game of chess, in which you were blindfolded? Wouldn't the buyer likely be the loser?

Well, as it turned out, the buyer was a chump. People who bought Blackstone shares when it went public last June have lost 55% of their money.

Of course, it's not just Blackstone that is getting beaten up. The whole capital structure is getting hammered. "Margin calls pummel hedge funds," says one headline. "Peloton [a prominent hedge fund that seems to be going bust] puts its offices up for sale," says another.

Meanwhile, Japanese financial regulators say direct losses from subprime troubles have risen to $215 billion. One estimate says they'll grow to $1 trillion before it is over.

While the geniuses are taking their lumps so are the lumpen. That is, ordinary homeowners are being beaten up too - not only by falling house prices and high debt, but by rising consumer prices.

Yes, dear reader. This is a two front war. In the middle, the middle classes are taking incoming from two directions. The value of their main assets - houses and their own labor - are being deflated, while their cost of living goes up. In terms of oil, gold, Swiss francs, euro or pounds - Americans earn substantially less per hour than they did 5... 10... or even 30 years ago. And they own less of their houses too. Americans' percentage of equity in their homes has fallen below 50 percent for the first time on record since 1945, the Federal Reserve said last Thursday.

But while they have less... and earn less... they still have to pay more. Gasoline is up to $3.20 a gallon, we reported yesterday... and oil hit more than $107 a barrel today. The dollar lost more ground too; it appears to be heading for $1.55 to the euro this week.

Producer prices are shooting up too. The PPI rose to 6.6% in China. And in Britain it's at a 17-year high.

"Consumer gloom as spending power fails," says the headline item in the TIMES of London today.

The Fed is fighting back, of course. But it's turned its guns only in one direction - against deflation. Inflation can run wild.

Investors have figured out what is going on. They're still buying U.S. Treasury bonds, but now they favor the TIPS - bonds adjusted to inflation. TIPS have been bid up so high that they now produce a negative yield. That's right, yields have fallen below zero... indicating how eager investors have become to protect themselves from defaults and inflation. Nothing is less likely to default than a U.S. Treasury bond... heck, the feds print the money used to redeem them. Ah, there's the catch - they tend to print too many, which results in inflation. As long as the inflation was going into house prices and stocks, no one complained. But now, housing and stocks are going down - while consumer prices rise. These TIPS provide protection from both enemies - inflation and deflation. The feds won't default. And the TIPS adjust to losses in consumer purchasing power - as calculated by, well, the feds themselves. But so great is the demand for this kind of protection that investors are willing to give up all hope of a current yield in order to own them.

Bill Bonner
The Daily Reckoning Australia

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