Private equity’s struggles

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Private equity after the great moderation

The stocks of the big private equity/asset management houses got clobbered during the recent market correction: 

This is not hard to explain. These companies are leveraged plays on the market, and the market went down. The stocks have also been on a great run for the past few years, and may have got ahead of themselves. 

But the big moves in the stocks reminded me of a couple of Unhedged letters written back in 2021, in which we presented a basic picture of private equity’s essential characteristics. The picture had five pillars:

1. The source of private equity’s extra returns, over and above analogous forms of public equity, is leverage. 

2. The talk about the advantages of taking a long-term view, or being insulated from the demands of public markets, or bringing highly specialised management techniques to bear is almost entirely nonsense. No one has ever shown any evidence for it that I know of.  

3. The reason that the “long term view” stuff is not entirely nonsense is that there is some reason to think that when private equity companies get into financial trouble — because of their high leverage or some other reason — private ownership makes a refinancing/restructuring easier than if it took place in public markets. This can minimise losses in moments of crisis, making the extra returns from higher leverage more sustainable. 

4. The reason that there is so much institutional investor demand for private equity is because it is not marked to market, which creates the appearance of uncorrelated returns in institutional portfolios. There is no liquidity premium in private equity assets. Instead, investors probably pay extra for the illiquidity. 

5. The reason there is so much supply of private equity assets is that in a time of fee compression for public market funds, you can still charge healthy fees for managing a private fund. 

It is important that this is not a sceptical view of private equity as a “billionaire factory” where investors get a product with an average-to-poor risk/return mix and managers get islands in the Caribbean. The view, instead, is that private equity embodies the discovery that many companies are (or were) financed with too much equity and not enough debt. If you correct that ratio under private ownership, and carefully manage the additional debt at tricky moments, you can make a lot of money. Investors in private equity get lower apparent volatility, and, if they are savvy, don’t pay so much in fees that the extra returns generated by the higher leverage are all captured by the fund managers.

But markets have changed a lot in the last three or four years. How is this business model holding up?

On one level, very well indeed. Assets under management for private equity buyout funds grew fast, at least through 2023. Demand for the product is strong. But there are problems in both putting the money to work in new deals and exiting deals so cash can be returned to investors. 

On the first problem, the latest Bain Global Private Equity Report says that while the backlog of unspent funds fell slightly to $1.2tn (!) last year, the amount of that money that has been idle for more than four years rose to 24 per cent of the total, from 20 per cent the year before. It appears that buyout targets at affordable prices are very scarce. This is unsurprising in a world where risk assets, especially in the US, are wildly expensive. 

The second problem is a bit harder to understand. It is summed in the chart below from Bain:  

“Buyout funds are holding almost twice the assets they were in 2019, but exit value is at about the same level,” says the Bain report. Why is it so hard for PE to sell companies? Markets are booming. Assorted explanations have been offered, including:

• There was a massive burst of buyouts in the years when animal spirits were high and interest rates were low, culminating in 2021. Then interest rates rose, which scrambled the economics of those deals and made exits at acceptable prices much more difficult.

• The decline of the long-only active equity manager, in favour of passive funds and multi-strategy hedge funds, has made the stock market a less friendly place for IPOs, a crucial exit channel for PE. Those long-only managers provided predictable demand that made IPOs less risky for sponsors.

• A tougher antitrust regime under the Biden administration — which may continue under Trump — made it harder to sell companies to industry buyers. 

None of this amounts to a crisis for the PE industry. Interest rates have come down recently, junk credit spreads remain tight, and the credit market is wide open. As long as that remains true, liquidity can be generated with dividend recapitalisations, secondary sales, or borrowing. Deal exits will happen slowly but surely, as they did in the recovery after the 2008 financial crisis. The industry’s problems, in other words, are basically cyclical.

Maybe. But it is worth asking if the private equity industry, at least at a multi-trillion-dollar, world-consuming scale, was to a large degree a product of the unusual global financial conditions that prevailed in the last 40 years, and especially after the 2008 crisis.

This is not simply the claim that private equity could not thrive under higher interest rates; it probably could. But for several years this newsletter has been among the many people wondering whether changing demographics, deglobalisation, and higher sovereign indebtedness are pushing us into a new financial and economic regime.

This new regime seems likely to feature not just higher interest rates, but higher inflation, higher inflation volatility, and higher term premiums on bonds. In sum, things may be much more volatile than they were during the “great moderation” of the decade following the 1980s. If this is true, perhaps the central idea of private equity — that most companies should be funded with more debt and less equity — is less true than it was. It strikes me as possible that what we have seen in the past few years are the stresses and strains of private equity adjusting to a new world. 

One good read

An ancient restaurant. 

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