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Business
The Economist July 9th 2022
Private equity
PE lessons
After several heady years private equity may be heading for a fall
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f investors in equities and debt mar kets will remember anything of the fi rst half of 2022 it will be generational selloff s. But the turmoil in public markets has not yet fully bled into private equity: fundrais ing has marched on, large deals are still be ing consummated and paper returns look strong. The blood, however, may be about to fl ow. Buyout barbarians made their names in the late 1980s, not the 1970s, for good reason. The corporate buyout is a fi nancial ploy unsuited to the coming per iod of slow growth and high infl ation; no previous boomandbust cycle in private equity’s 40year history has been like it. Most important, cheap debt is unlikely to be able to save the day. If trouble is to strike, it will hit an in dustry that is now hubristic and vast. The amount of money invested, or waiting to be invested, by privateequity funds has swelled from $1.3trn in 2009 to $4.6trn to day. This was driven by a scramble for yield among pension funds, insurance compa nies and endowments during a decade of historically low interest rates in the after math of the global fi nancial crisis of 2007
09. Many have more than doubled their al locations to private equity. Since 2015 the ten largest American publicsector pen sion funds have collectively committed in excess of $100bn to buyout funds. In the search for marketbeating re turns, some $3.3trn managed by private equity fi rms is currently invested in priv ate companies. A chunk of this refl ects the $850bn of buyout deals done during 2021 (see chart 1 on next page). It is not by the ge nius of privateequity bosses that this cap ital has been posting impressive paper gains (see chart 2). Rather, company valua tions have until recently been on a tear; low interest rates push up the valuations of fi rms, which have been chased by buyout fi rms armed with cheap debt. Buyouts → Also in this section
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have been increasingly common in sectors with the highest valuations, including technology, driving the average valuation multiple for American transactions to take fi rms private to 19.3 times ebitda (earn ings before interest, tax, depreciation and amortisation) in 2021, compared with 12.6 in 2007, according to Bain & Company, a consulting fi rm. The stockmarket crash this year will take months to wash through private mar kets. But a reckoning is on the horizon. Private equity benefi ts from a fi g leaf of illi quidity, resulting in a delay between real and reported fund valuations. In the ab sence of a liquid market to price invest ments, privateequity funds assess the cur rent “fair value” of their portfolio based on the price an investment would realise in an “orderly transaction”, which should look similar to the valuations of comparable companies in the public markets. But such “orderly” exits are drying up fast. Market turmoil means stockmarket listings are off the table and companies are thinking harder about spending cash on acquisitions ahead of a recession. Sales from one privateequity fund to another will not sustain an alternative reality of high valuations. For some fund managers, adjusting valuations will be painful. Funds which bought companies at a premium to skyhigh stockmarket prices will suff er signifi cant markdowns. Fund managers and investors accustomed to stable, mar ketbeating returns must accept the true underlying volatility of their investments.
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