Private equity meets bear market

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Is the fun over in private equity?

It has been a rough couple of days for private equity in the pages of the Financial Times.

Yesterday, Katie Martin wrote how Vincent Mortier, chief investment officer of Amundi, the largest asset manager in Europe, described parts of the industry as a “Ponzi scheme”, in which assets are passed back and forth between private equity houses at inflated valuations:

“You know you can sell [assets] to another private equity firm for 20 or 30 times earnings. That’s why you can talk about a Ponzi. It’s a circular thing.”

Mortier said the incentives are for private equity firms to transfer assets between each other at inflated prices.

“Just because there’s no mark to market doesn’t mean there’s no risk,” said Mortier. “There are some very, very good opportunities, but there are no miracles. Eventually there will be casualties, but that might not be for three, four, or five years.”

Back on Monday, Mohamed El-Erian took issue with PE managers’ claim that “this year’s large losses in public markets would drive even more investors their way”. He notes that PE valuations are not entirely immune to market fluctuations. Instead they lag them by six or nine months (I would argue that is how long accountants on the PE payroll can deny the blindingly obvious, but my work has made me cynical). And then:

Higher interest rates and tightening financial conditions will complicate the refinancing of leveraged take-private transactions. They make the paths back into the public markets less secure and the exit valuation less certain. They also curtail new investors’ enthusiasm for buying private equity stakes in the secondary market, putting pressure both on prices and volumes.

The worsening global economic outlook is also a problem. Downturns rob companies of actual and prospective revenues, leading to faster burning of cash reserves, increased debt burdens relative to equity and capital erosion.

The context for these dire pronouncements is an absolutely incredible 12-year expansion for the PE industry. Here are three indicative charts from Bain’s latest Global Private Equity report. Deals, deal values, exit values, capital raised — all up, up, up:

It has been a staggering boom, capped by an especially strong 2021. Now, I have argued at tiresome length before that returns to private equity investors have not beaten returns from large-cap US equities, and have underperformed them massively on a leverage-adjusted basis. That said, more recent returns have been very strong. From Bain:

Calculating PE returns and comparing them to public market returns is something of a dark art, but I think we can assume numbers from consultants like Bain or PitchBook (whose figures roughly agree) are at least directionally correct. Despite (at best) equalling the S&P’s returns over a decade, PE has outperformed in the past five years and especially in 2021.

Which brings us to Dan Rasmussen, founder of Verdad and a noted PE critic. A week ago, in a research note, he revisited an astringent criticism of PE that he published four years ago in American Affairs. Back then he pointed out that PE companies were using more and more leverage, and paying higher and higher valuations for acquisitions, and that the accompanying volatility was only concealed by generous marks. The whole thing will come to no good, he suggested.

Rasmussen has been, by his own admission, either early or wrong. In the past four years, PE returns have been strong. So what has happened? Rasmussen’s theory is that a few years ago PE shifted towards tech investments, and the timing was perfect. He writes:

Buyouts [since 2018] have shifted toward growth equity, with software and healthcare going from 15 per cent of transaction value in 2007 to ~40 per cent of transaction value in 2021 according to PitchBook, numbers that probably understate the shift . . . and this shift from value to growth coincided with a period of exceptionally strong returns for small growth.

I called Rasmussen, and we talked about what this means for the future. He thinks we should be looking at the collapse of other forms of growth investment:

What you have seen in the last decade is PE shifting into small growth equity and becoming more like venture, but still using more leverage — and that leverage is mostly floating-rate debt, by the way. I’d estimate that tech or tech-enabled businesses are 50 per cent of deals in recent years.

You see what has happened recently to other investors in small-cap tech — venture capital [down 46 per cent this year according to one index], Cathie Wood’s Ark [down 69 per cent from its peak], and Tiger Global [lost two-thirds of its gains since 2001]. 

What private equity owns is small, probably not as small as what venture capital owns, but there is a spectrum. What should PE’s tech investments be marked down? 30-40 per cent? They won’t be, but they probably should. And then they have the special problem of leverage.

Assessing all these criticisms, it’s worth noting that at this particular moment it’s easy to be a sceptic about any investment or asset class. Rates are rising, growth is slowing, valuations are high, housing looks rickety, and sentiment is poor.

Of course the PE doubters are right about the industry’s worst excesses, such as the circular transactions Mortier targets. And El-Erian is right that anyone who thinks that, in a recession, private equity will skate through because PE funds do not mark to market or because the industry has spare capital, is in for a surprise. These are not huge revelations, though.

The bolder, trickier question — which Rasmussen implies — is whether valuations and leverage in PE have now been stretched so far that the next big recession will be even worse for private equity than the last one. The 2007-08 crisis led to spectacular blow-ups of individual buyouts, such as Freescale and TXU. But industry-wide returns did not diverge much from public equities through the crisis. PE was bad, but not much worse than the alternatives.

This time round, having shifted to growth companies and pushed the valuation/leverage envelope, can the industry muddle through again?

One good read

If you have not had enough criticism of private equity, here is an oldie but a goodie from Cliff Asness of AQR Capital Management.