In a book I’m reading these days, it says too much capital chasing too few LBO deals is problematic. How can this be problematic? Too much capital chasing lot of deals could turn out bad. But, if there are too few deals at the market, the capitals are not going to be invested in these high-risk investments, and rather invested in somewhere else. How can be this statement explained?
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It's mainly problematic for the LBO shops. Many large LBO shops still have a ton of committed capital that they need to find some way to put to work. LPs don't like to pay 2% management fees on capital that remains idle. While debt is scarce and there is an over-abundance of LBO capital in the market, LBO shops are having a hard time finding attractive investments at attractive valuations.
Let me know if any part of that is unclear and I can explain further.
Then, I guess it’s mainly problematic to one party. But, it really doesn’t seem to be a problem for the whole economy, right? Unless, these capitals are funded somewhere, there will be no risk. No action, no risk, right?
No action no risk ... but also no investment and no growth. The economy needs debt and credit to be available to facilitate investment, which drives growth and jobs creation.
"Beware of geeks bearing formulas", Warren Buffet. So you don't need complex formulas to explain this. Too much capital chasing a company for sale (buyout) is like having an auction in which there are too many bidders all cashed up. What ever is being auctioned you can bet it is going to be sold at a price much higher than if there were only a few not cashed up bidders. In many cases people who are prepared to pay a realistic price are going to be out bid by irrationally exuberant bidders who will later regret the purchase, but by then it doesn't do the rational bidder any good, he has lost out buying that item at a realistic price. Because there are limited items in this auction the realistic bidder can lose out on every item. Going back to the LBO scenario this means that the fund cannot find a company to buy at a realistic enough price to make a profit or has to take on unacceptable risk to do so.
This is pretty much it. As to spinner's comment - LPs typically pay management fees on called/deployed capital and not committed capital. In fact, many LPs these days are strapped for cash and do not want their capital called in the short-term
Your are right that sometimes LPs don't pay management fees on uncalled capital. You are also right that many LPs are sending strong signals to funds not to call their capital. It is also true that some funds are currently letting some of their LPs out of their commitments and/or foregoing some management fees. However, the industry standard is still that funds are paid management fees based upon committed capital rather than called capital. Doing it the other way would give PE funds too much incentive to push as much money out the door as fast as possible to gain the management fees.
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