Is Private Equity about to implode?

Every crisis has a response. In their effort to prevent it from happening again, policymakers put in safeguards and provide incentives for the next bull market. In these policies, we should, usually, seek the seeds of the next crisis. From the biggest potential risks, the Private Equity space is where we would focus.

In the 1970s, the world experienced a decade of slow growth and high inflation. In their effort to put a stop to it, central banks launched interest rates at very high levels. Desperate homeowners were, anecdotally, sending their house keys to Paul Volcker, the Chair of the Federal Reserve in the mid-1980s. To balance the equation and foster growth again, governments defanged laws preventing banks from leveraging their deposits to give out more loans. It enabled banks to essentially create money. However, risks for depositors rose, without compensation or their knowledge.

The 2008 Global Financial Crisis (GFC) was about twenty-five years of banks taking increased risks with their clients' deposits. It got so bad, that banks were happy to give out loans to people who could never hope to repay them, and then try to pass on the risks to others. Governments knew that it was their own de-regulatory efforts that led to this result. “Too Big to Fail”, bad as it sounded, was probably more politically palatable than “We had to do something twenty-five years ago”.

The response to that crisis was as expected. Regulators relaxed oversight and made sure private investors had enough tax incentives to pick up the investment baton. The central banks would print enough money to keep risks and interest rates low enough to foster investments, and then deliberately kept the banks off of the party’s guest list. Banks were re-shackled, becoming the boring institutions they were five decades before. No more proprietary trading desks or super-leveraging deposits.

A decade of ultra-low-cost of capital signalled the rise of Private Equity investing. Many companies even opted to remain private, rather than raise money through an Initial Public Offering. Over the past twenty-five years, the number of US public companies declined by a third, and the remaining pool is dominated by a handful of tech companies.

Houston, we have a (valuation) problem.

Currently, Private Equity companies have a valuation problem. The valuation of a company depends on the amount the last investors put in.

Let’s use a company called TechX as an example. TechX produces equipment with haptic feedback for game consoles and the metaverse. During the time of cheap money, a venture capitalist invested 20 million from its one-billion-dollar pool to acquire 2% of the company. The stake was purposefully low. With a small amount of money, an influx of just $20m, the company is now suddenly a $1bn “unicorn”, although it has never seen that amount of money. That status is set to attract even more investors.  Private Equities (a step up in terms of capital and scrutiny from venture capitalists) would now put TechX on the radar. They might offer less generous valuations terms, but still big enough for the company to grow exponentially.

By the next year, the venture capital (which usually has little interest in investing in the next phase of the firm’s growth) can make a profit from the Private Equity money and leave.

Venture capitalists and Private Equities adhered to the so-called “Power Law”. They needn’t get every investment right just a few of them right, and those few would result in big payoffs.

The system worked – provided money remained cheap, as it allowed private investors to spread the money. Venture capital and Private Equity could spread the wealth and build company valuations up, with small risks, all the way until a company was listed on the stock market.

While no one assumed that zero interest rates would last forever, high levels of global debt (360% of global GDP), low levels of investment and the chronic absence of inflation led to the natural conclusion that they would remain low for a very long time.

However, the resurgence of global inflation, resulting from tectonic geopolitical shifts, upended this process. As the cost of money rose, so did the opportunity cost for those funds. At the same time, their own capital is drying up. Pension funds, and other big organisations that could not find a yield in bonds, would expand to equities and Private Equity. However, as the risks rise, and bond yields with them, they are now beginning to trim their exposures. Pitchbook, a news outlet for Private Equity companies, said in February that “Private Equity returns are a major threat to pension plans’ ability to pay retirees in 2023”.

The calculus now changes. Private Equities and venture capital firms can no longer spread their money as much, meaning the probability of severe capital losses mounts. As a result, they are less able to invest in new companies, instead focusing on squeezing value out of their current exposures.

Global deals have sunk to their lowest levels in over a decade. In April, Blackstone, one of the world’s largest Private Equity firms, stopped redemptions for some of its funds. Global M&A volumes have collapsed. The ten-year average M&A volume stood at $3.8tn at the end of 2022. For 2023 so far (until the end of April) the total value of deals reached was around $700bn. Even if this figure were tripled (which would imply that further rate hikes will have zero impact), the number would still be half of the average annual volume of the past decade.

As time passes, the valuation method changes. It’s not just what someone paid for a company a couple of years back. It is the profits this company should be now making. If it hasn’t lived up to expectations, and another expensive infusion of cash is out of the question, then naturally valuations will drop, dramatically. Losses could especially be understated in the real estate part of that market. The end of the US fiscal year for pension funds, at 30 June 2023, could reveal surprises.

What are the market repercussions of a potential Private Equity meltdown?

The largest problem with the Private Equity market is that it is opaque. No one knows the underlying figures and potential exposure to risk.

One could argue that the implications from the potential implosion of the Private Equity market are not systemically important. After all, that was the plan; take the risks away from banks and put them on private investors. The Private Equity market is not very big. The total value of Private Equity capital invested worldwide in 2022 was an estimated $12tn, with $3.7tn in “dry powder”, capital pledged but not deployed, according to Statista. It is dwarfed by both the global equity market, which is worth $109tn and the global bond market $133tn, which at the end of 2022.

However, history has proven that this may not be the case. Assets tend to find connections we currently cannot account for. In 2007, the US Subprime Mortgage market was estimated at $1.3tn, a tenth of the current Private Equity market and just 14% of the total mortgage market. Yet, its implosion (which was not wholesale), sparked the largest financial crisis in a century, the consequences of which are still visible today in every sphere of the economy, finance, and politics.

Having said that, we think that the final impact will likely prove muted. Not because it is an isolated market, but rather because the Federal Reserve has a sound strategy, which it deployed during the March Banking crisis.

At the first sign of a credit crunch, it will deploy credit lines and other measures very quickly and at strength, which may help put out the fire early. Those measures expand the balance sheet but do not necessarily counter rate hikes, as they have little impact on long bond yields (other than reducing their volatility) and thus mortgages. The tactic worked after the collapse of SVB, keeping risks at bay.

When do we think risks for the Private Equity market will abate?

The short-term outlook is challenging. Valuations will be lower, and capital is less readily available. The longer-term outlook is also not necessarily positive.

On first instance, it appears that the Private Equity market woes stem from higher interest rates and macroeconomic volatility, and thus pressures would remain transient. Opportunities will remain abundant for the time being. Authorities seem intent on tightening banking regulation and thus credit, leaving more opportunity for Private Financing.

This is where the good news ends. A decade of ultra-low yields has reduced the cost of money and also driven many investors into alternative sources of financing. A normalised and higher yield curve will drive investors away from the Private Equity sector over the longer term. Financing will become scarcer and more difficult to obtain and pension funds will have viable alternatives.

We should expect some pressures to abate about a year after the Fed is finished with tightening rates, i.e. around 2025. An easier macroeconomic backdrop and lighter credit conditions could help improve the flow of deals. But we should not expect pension funds and other big players who saw the asset class as an alternative to zero-interest fixed income to return en masse.

Additionally, over the longer term, we should not expect heavy bank regulation to last ad infinitum. The regulation-deregulation tug-of-war has tilted far into the side of regulation. The next iteration, whenever that may come, would probably include lighter regulation. That could have already happened, not for the US banking crisis in March.

We feel that, barring a turn in fortunes, the golden age of Private Equity might be behind us. Private Equity owners had a chance to introduce their funds to the wider market, and that’s good. Now, they will have to think of more ways in which their product can become appealing to institutional players in the age of higher yields.

George Lagarias, Chief Economist

A shorter version of this article appears in the FT Adviser.

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