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Private equity’s fragile future
Private equity PE lessons
After several heady years private equity may be heading for a fall
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If investors in equities and debt markets will remember anything of the first 09. Many have more than doubled their allocations to private equity. Since 2015 the half of 2022 it will be generational selloffs. But the turmoil in public markets has not yet fully bled into private equity: fundraising has marched on, large deals are still being consummated and paper returns look strong. The blood, however, may be about to flow. Buyout barbarians made their names in the late 1980s, not the 1970s, for good reason. The corporate buyout is a financial ploy unsuited to the coming period of slow growth and high inflation; no previous boomandbust cycle in privateequity’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 industry 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 today. This was driven by a scramble for yield among pension funds, insurance companies and endowments during a decade of historically low interest rates in the aftermath of the global financial crisis of 2007ten largest American publicsector pension funds have collectively committed in excess of $100bn to buyout funds. In the search for marketbeating returns, some $3.3trn managed by privateequity firms is currently invested in private companies. A chunk of this reflects the $850bn of buyout deals done during 2021 (see chart 1 on next page). It is not by the genius of privateequity bosses that this capital has been posting impressive paper gains (see chart 2). Rather, company valuations have until recently been on a tear; low interest rates push up the valuations of firms, which have been chased by buyout firms armed with cheap debt. Buyouts have been increasingly common in sectors with the highest valuations, including technology, driving the average valuation multiple for American transactions to take firms private to 19.3 times ebitda (earnings before interest, tax, depreciation and amortisation) in 2021, compared with 12.6 in 2007, according to Bain & Company, a consulting firm.
The stockmarket crash this year will take months to wash through private markets. But a reckoning is on the horizon. Private equity benefits from a fig leaf of illiquidity, resulting in a delay between real and reported fund valuations. In the absence of a liquid market to price investments, privateequity funds assess the current “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 suffer significant markdowns. Fund managers and investors accustomed to stable, marketbeating returns must accept the true underlying volatility of their investments.
→ Also in this section 64 Poland’s precarious businesses 65 Europe’s unicorns ride on 67 Bartleby: Corporate culture 68 Schumpeter: The Ambani empire
