Of all the surprising casualties of the Fed's massive rate hikes--regional banks! SVB!--could the private equity industry find itself on the list?
After all, the industry's massive growth--from less than $2 trillion to $4.4 trillion in size as of last year--came during the past nearly-fifteen years of "ZIRP," or zero interest rate policies. Ultra-low interest rates make the economics of using cheap debt to buy small companies at a low valuation and selling them at a higher one look pretty attractive. But high interest rates undermine that whole model.
Indeed, last year ended with a "sudden reversal" of the "up cycle" that "has endured since 2010," wrote Bain in its annual review--and that was without even fully knowing how bad fourth-quarter returns were. Returns were down 10% through the first three quarters, according to Goldman.
And that underperformance is already threatening the funding status of public pension funds, which have invested heavily in this asset class in recent years--in some cases, up to 40% of their portfolios. The "funded ratio" of public pensions as a result is expected to drop from nearly 84% to just 77% on average, according to Equable--which is "lower than the funded ratios in 2007 and 2008, just before the global financial crisis," as Pitchbook notes.
Was 2022 just an unusually bad year, because private equity as an industry is overexposed to software companies, and tech was the worst-performing sector? If so, that would be an easier pill for investors--which also include many college endowments--to swallow. But there are worries that its troubles could run deeper, and be more persistent unless interest rates return to ultra-low levels.
For starters, the superior returns that private equity could claim to have generated (in order to justify its lofty fees) versus investing in the public markets appears to have evaporated. "In the decade leading up to 2022, surging values of U.S. public equities had closed the historical gap with private equity returns," Bain has acknowledged.
Secondly, the characteristics of many private equity portfolios are similar to owning small-cap U.S. stocks--traditionally the most volatile and least desirable part of the equity market for many institutional investors like pensions. The average deal size for a target company last year was $964 million, according to Bain; almost identical to the median market cap of a company in the Russell 2000, of $922 million.
So how has private equity outperformed--if indeed it has? "The data is clear: private equity returns have come largely through multiple expansion in recent years, rather than from revenue and margin growth," Bain warns. "But [they] won't have that luxury going forward, as higher rates continue to put downward pressure on asset prices."
Proponents would argue that private equity is not apples-to-apples with the Russell 2000 because it overwhelmingly invests in technology (especially "sticky" software companies), and healthcare, whereas the Russell has more exposure to sectors like industrials and financials. But industry watchers also admit that absent cheap debt and growing multiples, the only path to higher returns from here lies through growing market share--which may be difficult (and much costlier) for all portfolio companies to try and do at the same time.
Some critics have even gone as far as Cliff Asness (and Warren Buffett) in accusing the industry of "volatility laundering," or in other words, hiding the real volatility of owning what are basically often just small-caps behind the "smoothed" quarterly returns the industry is allowed to provide.
One thing is for sure: we are starting to see some signs of desperation emerge. "Private equity funds have started to borrow against their funds to backstop overly indebted portfolio companies," the Financial Times reported last week. Such moves to "defend the portfolio" come "as many older private equity funds run low on cash just as the companies they own struggle with their debt loads," the piece noted.
Private equity firms hope these loans can be a bridge to a more profitable market in which they can sell, or "exit," their investments. "They have remained loathe to sell at cut-rate valuations," but the loans themselves "could be a big drag to overall (future) performance," the FT warns.
The private equity business may yet figure out how to weather this storm, but its challenges are mounting unless "ZIRP"--or IPO euphoria--soon returns.
See you at 1 p.m!
Kelly
