My last few blog articles have been on the private equity industry, and further digging in recent days led me to the discovery of Dan Rasmussen. He has some excellent insights on private equity and has made a number of useful podcast appearances outlining his thoughts on the subject (available on YouTube), which I have spent the past day or so devouring. They come highly recommend.
His conclusions broadly mirror my own more intuitive conclusions, but he is in possession of more hard facts and data; has first-hand experience working in the industry (at Bain); and was able to put some extra nuance around various issues I was previously lacking. I appreciate his important contributions. I have incorporated many of his insights with my own into this narrative take on where we are, and how we got here, and what the future may hold for the PE/PC industry. I hope you enjoy!
“What the wise do in the beginning, fools do in the end”
Warren Buffett
The golden age of PE – at least from the standpoint of investor returns (FUM and thus fees to sponsors were significantly lower) – was during 1980-2000, and at a slight stretch, to around the time of the GFC. During this era, PE delivered legitimately good returns – in some cases outstandingly so. What enabled it was that it was still a niche industry where there was a limited amount of capital chasing deals, while the backdrop was conductive. Asset prices were cheap after the savage inflationary 1970s bear market – a period that concluded with very high interest rates, depressed multiples, and much in the way of undervalued tangible assets (due to years of cumulative high inflation understating book values). Moreover, corporate governance was poor in the 1970s and riven with agency conflicts, resulting in a lot of room for “value up” optimised capital allocation a la Japan and South Korea today. Lastly, in the decades that followed, interest rates sharply declined while asset prices rose – nay boomed – and PE had used high amounts of leverage, which magnified gains. The opportunity was ripe, competition was limited, and everything subsequently went right.
Rasmussen makes the point that during this era, despite
the occasional high profile bidding war for public companies, PE were for the
most part buying predominately small, private businesses, and buyout valuations
were typically about 40% below listed peers, reflecting limited bidder competition
and a large “illiquidity discount”, and this was at a time when asset prices in
general were also not expensive. A combination of value, an illiquidity
discount, and high leverage during a period of declining rates and rising asset
prices led, not surprisingly, to excellent returns.
Returns declined in the 2000s but still remained
respectable (aided by a tailwind of a major decline in interest rates through
the decade), particularly relative to the poor outcomes the US equity market
delivered, which featured not one but two major bear markets – the dot.com bust
and the GFC. On both occasions, the S&P 500 fell approximately 50%, and on net
US equities suffered a lost decade, while the wild swings/volatility seen in
the listed space during this period unnerved many investors, and made the seemingly
low volatility (not to mention the above-average returns) of the PE asset class
appear particularly attractive.
What was now a 30yr historical track record of
outperformance, coupled with PE’s seemingly uncorrelated volatility resilience;
the poor performance of US equities during the 2000s; and the quickly vanishing
yield available on publicly traded debt instruments by decade-end, made PE look
like a highly desirable asset class. Early investors into PE looked like geniuses,
and PE merchants looked like proverbial masters of the universe. Not only were PE
vehicles delivering high absolute returns, but they seemed to be doing so in an
“uncorrelated” manner with limited drawdowns – it was an asset allocator’s
dream.
Accordingly, fund raising was easy, and as more
investors flocked to get in on the action, thousands of copycat “alternative”
asset managers cropped up to cash in on the demand – attracted also by the very
high fees (typically 2 & 20) they were able to charge. The attractiveness of
alternatives management to traditional fund management purveyors was also
bolstered by the waning attraction of typical funds management, which was
rapidly losing market share to passive vehicles/ETFs and suffering fee
compression. It wasn’t long before everyone was clamouring to get into alternatives
management.
The problem was that the same thing that always
happens when too much money floods into an area happened – bidding competition
heated up, target prices rose, and the opportunity that previously existed
rapidly disappeared (though the vehicles’ high fee structures of course remained
firmly intact). In contrast to the 1980-2000s, Rasmussen believes that private
equity funds from the 2010s were paying a premium to public market
valuations for (typically) small, subscale and illiquid businesses. Not
surprisingly, since the 2010s, and perhaps as far back as 2006, outcomes have
dramatically changed, and PE has delivered generally disappointing returns and
underperformed listed equities, and the magnitude of that underperformance has significantly
worsened since 2022.
That the 2010s was a period of underperformance would
be vigorously denied by the PE industry (though they wouldn’t deny it since
2022), but there is ample evidence PE has been obfuscating return outcomes in
self-serving ways. A number of academic studies have been conducted, relying
not on PE furnished data but on the realized return outcomes of end
investors/endowments, and they have concluded the industry has underperformed
listed equities from at least 2010, and some show since as far back as 2006. Warren
Buffett has noted that he had scrutinized PEs return calculations and found
them to be “well, they’re not calculated in a manner that I would regard as
honest”.
All kinds of tricks can be and are used to inflate apparent relative returns. For a start, PE will often lock up commitments from investors years in advance, and only “call” the funds much later after a deal is done. The IRR calculations only include the period during which the funds are working, but investors need to keep cash in reserve as it can be called at any time, meaningfully diluting effective returns to investors. In addition, comparative equity benchmarks are cherrypicked. If you scrutinize the footnotes, you will see that private equity often benchmarks its return against the Russell 2000 or MSCI Global, which have radically underperformed the S&P 500 over the past 15 years.
While some might argue a small cap benchmark to be defensible given the typically small size of PE companies (see discussion below), the reality is that: (1) the industry is not holding itself out as offering an alternative to small cap stocks specifically – it is marketing itself as an alternative to listed assets in general; and (2) it is almost certain that had the Russell 2000 and/or MSCI Global sharply outperformed the S&P 500, that the industry would be using the S&P 500 as its preferred benchmark.
And all of this is only the tip of the iceberg. You
can also cherry pick reference funds, shuffle asset between funds, etc. And all
of this is before confronting the elephant in the room – the PE industry is currently
“marking to model” and is sitting on a vast number of assets it is unable to
sell – even in a bull market – because the marks are unrealistic. This will be meaningfully
inflating claimed trailing returns, which remain mostly unrealized. The truth of
the matter is that PE returns started to meaningfully degrade in the 2010s, and
the underperformance has sharply accelerated since 2022.
One of the most important points Rasmussen makes
that I did not realize, is just how small the average US PE investee is today –
approximately US$200m in equity value and about US$500m in EV, across an
industry that has now amassed about US$2tr in equity value and US$3tr in
private credit (though this is only 10% of the S&P 500’s US$50tr). This has
significant implications for risk, which will be discussed later. Moreover, while
exact numbers are not available, a significant portion of private credit
appears to be lending to buyout (PE) funds. ChatGPT, quoting S&P Global
Market Intelligence said that 77% of buyout financing was provided by PC as of
2024 (I have not independently verified this but it seems plausible). Incidentally,
investors heavy in alternatives that believe they have “diversification” in
holding both PE and PC may be deluding themselves.
I noted in a prior article that for takeouts of
listed companies, private equity players typically had to pay a steep 20-30% buyout
premium, but they receive no such premium on exit. This was one challenge the
industry faced, amongst many (including very high fees), in delivering decent
returns. I received some pushback, noting that many PE targets are private
businesses, which is fair, but the practical outcome is the same – in the
private markets, too much PE capital resulted in aggressive bidding competition,
while private owners also need to be offered attractive buyout prices to be
willing to sell. The result was the same – an entry premium difficult to
recapture on exit. Remember, if there are multiple bidders for an asset, the
most optimistic and least risk averse party willing to write the biggest cheque
will win. PE was paying a premium in the private market as well.
Since 2010, with historical entry discounts and
illiquidity premia gone, there were only two ways in which private equity could
potentially deliver superior returns – either via “operational improvements” in
their investees, or via financial engineering/aggressive leverage to capture
capital structure arbitrage. That they have failed to deliver superior returns,
even with a tailwind of 12 years of zero rates (that should have hugely
facilitated the latter cap structure arbitrage and significantly advantaged
leveraged equity), and meaningful terminal year overvaluation of their yet-to-be
realized assets, speaks to how much value the industry has actually destroyed through
a combination of overpayment, operational mismanagement, and excess fee
gouging.
I expressed scepticism in my prior article about
private equity’s ability to extract operational improvements from investees,
and Rasmussen made the great point that if you look at who private equity
companies hire, it is typically ex investment bankers (this is consistent with
my empirical experience also – almost all of the young guys who worked in the
investment banking department of the bank I used to work for in a prior life
are today working in private equity). These guys are deal makers and spreadsheet
jockeys, not operational people, and there is no reason to believe they have any
unique insights on the intricacies of running small, niche businesses, where
specialised skills and decades of domain experience generally count for a lot
more than general smarts. Not to mention that as the industry has mushroomed in
size, the average quality of the average hire has meaningfully degraded and –
shall we say politely – increasingly regressed to the mean. Investment bankers
also, I might add, generally lack investment acumen. They are deal makers – a different
skillset entirely.
I would now go even a step further – I think it
is probable that on balance, private equity ownership not only fails to deliver
operational improvements, but very likely on net makes the operational performance
of companies worse, particularly in the long term. The most obvious
means by which this occurs is by saddling investees with significant levels of debt,
as well as implementing wholesale asset stripping (such selling and leasing
back real estate) and cutting operational costs and capital expenditures to the
bone. They frequently don’t just cut the fat, but the muscle as well.
Large debt burdens significantly reduce operational
flexibility and impair an organization’s ability to engage in long-term
thinking and investment, and to invest countercyclically. It is apt to create
the opposite environment to Jeff Bezos’ famed approach at Amazon – making long
term investments that take years to pay off that others are unwilling to do, and
engaging in multiple experiments, many of which will fail. If you are leveraged
to the eyeballs, you cannot afford to make large investments with unclear, long-term
payoffs, or take the risk of experimenting on new ventures that could fail. Moreover,
you are apt to underinvest and run the business for maximum cash extraction in
the near term, jacking up prices, lowering service quality, and squeezing
employees, and in the process alienating customers and opening the door to
competitor inroads. While this may improve near term cash generation, it often
comes at the cost of long-term value degradation.
There are vast numbers of anecdotes suggesting
this outcome is far from unusual. PE has now taken over a large portion of Las
Vegas, for instance, and visitors now routinely complain of high prices, poor
customer service, the removal of perks such as free drinks that previously
endeared visitors to the strip. Visitation has been waning, and people complain
Vegas has lost its charm, and has become overpriced and soulless, a victim of “corporate
greed”. While in yesteryear the strip was run by sometimes shady characters,
they at least understood the importance of looking after your customers and
ensuring they had a good time; they knew nickel and diming customers was a
short-sighted strategy. This is far from the only anecdote. Employees and
customers of PE backed hospitals and dental practices often complain of declining
service standards, high prices, and a significant increase in unnecessary treatments
unethically prescribed to boost near term utilization/billing. While again, in
the short term this may increase cash flow, it often comes at the cost of a
loss of consumer and employee trust, and can entail significant long term value
destruction.
The other avenue of juicing returns is to borrow
large amounts of money, ideally at low rates, and amplify equity returns
through leverage. If all goes well, this can indeed increase reported equity
returns, but it is a low-quality source of additional return; there is no alpha;
it is a return stream that comes simply through the assumption of greater risk –
leverage magnifies gains and losses. Private equity was a significant beneficiary
of the very low rate environment that prevailed during the post GFC era, which
helped them get away with this sort of capital structure arbitrage. And yet they
still managed to underperform. It was not a total disaster, however. They still
made money – just less than listed equities – and were beneficiaries of a
benign environment featuring solid economic growth, low interest rates, and rising
asset prices (particularly beneficial to those who are levered).
However, it was unlikely that perfect environment would
persist forever, and if the industry was already underperforming in a benign
environment, it was probable the results in a less benign environment would be much
worse. And so it has proven. While the economy has remained ok and asset prices
have continued to rise, since the onset of the post-covid era, inflation and
interest rates have sharply risen. In some contexts “two out of three ain’t bad”,
but not for PE – the loss of just one of these tailwinds is already proving
disastrous. It is not a co-incidence cracks have started to appear since 2022, coinciding
with the onset of higher rates, and conditions since then have continued to
steadily worsen. One reason for this is likely that debt taken out in more
benign rate eras is increasingly maturing and needing to be refinanced at higher rates. The vice is tightening. God help the industry if we also have a
recession and sharp decline in asset prices!
Make no mistake, the situation is grim. The
private equity industry today finds itself loaded up in relatively small, lower
quality businesses that they paid a premium to acquire in a competitive bidding
environment; are levered to the gills with previously low-rate debt that is now
repricing higher; and if that wasn’t enough, are likely now starting to feel
the operational consequences of years of underinvestment and other exploitive
business practices. Many of their investees have likely already become part of
the “living dead” – zombie companies that are eking out just enough cash flow
to meet minimum debt service obligations, but who are not growing, investing, making
any progress deleveraging, or delivering any returns to equity holders. Rasmussen
estimates that as many as 50% of PE investees may now be cash flow negative net
of debt service.
The canary in the coal mine was a sharp decline
in investor distributions, which has been the trigger for some of the long-festering
rot to begin to surface. Since 2022, PE funds have found it increasingly
difficult to sell assets – a peculiar outcome given that equity prices are at
all time highs. One of the reasons for this – besides the assets being
overvalued in the private market/on paper – is that one of the major vectors of
PE asset realizations in the past was the sale of assets to other private
equity vehicles – in other words, industry-level asset shuffling. This
required not only continued growth in PE fund raising (which has Ponzi like
characteristics), but also continuing low rates, because if you had previously
levered targets to the maximum level of debt their EBITDA could support, if the
cost of new debt rises, the price new PE vehicles could afford to pay would
naturally go down. The multiple of debt to EBITDA you can carry is radically
different at an 8% cost of debt than a 4% one.
For this reason, distributions to investors
started to dramatically slow from 2022, and have continued to fall precipitously.
According to Rasmussen, distributions (which include the return of capital)
have fallen from 30% to 10% during this period, and continue to decline. 10% may
still sound reasonable, but it is important to recognize that the largest source
of the funds for these distributions is still coming from asset shuffling
between PE companies and funds, as well as in some cases, incremental
borrowing. In the past, distributions were a source of reinvestment demand from
end investors, and many of those new funds were purchasing assets from existing
private equity vehicles. A reflexive dynamic has now been kicked into gear where
falling realizations have started to crimp new fund raising, which is in turn reducing
realizations/distributions, further reducing fund raising, etc.
Moreover, falling distributions have begun to
cause disquiet amongst LPs, long accustomed to regular PE payouts and the asset
class being “set and forget”. This unwelcome surprise has prompted institutions
with large PE allocations to, for the first time, begin to scrutinize their
exposure to PE/PC, ponder the risks, and question whether perhaps they may be
overallocated (in other words, start to do the analysis they should have done before
they allocated huge amounts of their capital to high fee, non-transparent,
and illiquid products). This is also reducing new fund demand. Rasmussen notes
that gross PE fund raising has declined sequentially every year since 2022, and
it continues to fall.
As end investors have not only expressed growing
displeasure with the lack of distributions, but much more importantly for PE
sponsors, have begun to reduce new fund commitments as a result, the private equity
industry has been scrambling to new find new ways to fund distributions. In
theory, they could of course just sell assets to third parties, but for the
reasons discussed in my past article on the lack of IPOs, the problem is they
are carrying their assets at inflated marks – there are no buyers at their fanciful
mark-to-model prices, and at-market liquidations would likely entail 30-50% equity
write-downs or worse – particularly because the assets are highly leveraged.
Instead, “continuation funds” are being launched,
that aim to buy out assets from one vehicle and shuffle them into another new vehicle
run by the same sponsor. Alt managers are using private banks to push them,
incentivizing them with large distribution fees to stuff their unsuspecting
clients into these toxic products. I sat in on one private bank pitch to a HNW
client in an advisory capacity, and was “amused” (to put it lightly) to see
them try to pitch it as an “alignment of interest” that sponsor-affiliated
entities would hold a meaningful minority of the new funds NAV, “investing
alongside investors”, by contributing not cash of course, but existing assets PIK
(payment in kind). What they were actually doing was injecting junk assets they
could not sell at inflated valuations into the new vehicle, and attempting to
dilute their exposure down through external capital. The idea this was an alignment
of interests was laughable – it was the exact opposite.
“Dividend recap” loans have also started to become
more common, where PE vehicles borrow money to fund distributions to end
investors, but at the cost of further worsening their leverage position. But
they are fighting a losing battle. In the past these types of shenanigans might
have worked, but investors are starting to wake up and view PE/PC with an increased
degree of much needed but vastly belated scepticism. And the industry is
starting to run out of patsies.
Pension funds and endowments are already maxxed out;
many of the latter – notably US college endowments – have allocated as much as
40% of their portfolios to PE/PC – a spectacular feat of ineptitude that
portends decades of coming underperformance. As noted, the PE/PC industry is aggressively
targeting high net worth (HNW) individuals and family offices through the private
wealth banks, but they are not at an early stage here either. It is believed
that as much as 30% of the revenue generated by private banks now comes from
commissions on stuffing their clients into alternative assets, and many family
offices in Asia already have allocations as high as 50-60% to US PE/PC, and they
are becoming increasingly nervous. This vector of fund raising also appears
more challenged moving forward (and incidentally, will significantly pressure
the profitability of private banks).
PE/PC has also succeeded in shovelling Middle
Eastern sovereign wealth funds into their products – entities that have a long track
record of being behind the curve and reliably buying heavily into the peak of
every cycle, at exactly the wrong time and price. Their reputation as being the
world’s most reliable contrary indicator will no doubt remain intact with PE/PC,
but in the meantime they are functioning as a useful dumping ground for PE/PC
continuation fund toxic waste and other otherwise unmarketable overpriced alt junk.
But even these sovereign funds will have eventual limits to their appetite, and
after years of future poor performance, their appetite will also eventually sour.
They are also highly sensitive to fashions, so if PE/PC falls out of fashion
globally, the Middle East will follow.
Middle Eastern sovereign wealth funds can,
however, afford to absorb large losses on private market holdings. More
worrying is that PE sponsors have begun to buy life insurance companies –
entities that have large investment portfolios backing their long-term liabilities
– pensions, annuities and other savings products, and life insurance policies. Life
insurers are highly leveraged institutions that are also highly regulated, so they
have historically invested conservatively (mostly in high quality fixed income).
However, private credit sponsors have found a way to exploit loopholes in
regulations designed to protect main street’s retirement savings and life
insurance policies from reckless hands.
Highly-rated debt instruments (by credit rating
agencies) require smaller amounts of regulatory capital, so what the PC
industry has been doing is shopping second-tier ratings agencies for favourable
credit ratings on private credit products, in echoes of the rating agency debacle
that contributed meaningfully to the GFC. Inflated ratings will allow alt
companies to shovel vastly more highly risky private credit funds/structured products
onto life insurance balance sheets with low levels of regulatory capital, while
also using captive insurance balance sheets as a dumping ground for toxic PE
assets. Given the size and leverage of insurance companies, this is a potential
systemic risk.
The procurement of corruptly-inflated debt
ratings is not the only bad practice alt/PC funds are engaging in. In a recent report, ASIC noted
that private credit funds sometimes lend money to an SPVs the sponsor owns,
that then have that SPV on-lend to end borrowers at marked up rates, with the sponsor
pocketing the difference! This is absolutely outrageous, and I was shocked to
learn it has become a fairly common practice. The lack of transparency is enabling
all manner of bad behaviour and unhinged greed to run amok, but many of the world’s
supposedly most sophisticated institutions nevertheless lined up to pile into
these products, and it is now too late to undertake due diligence – their capital
is locked up and it could take decades to get it out, if they ever can.
Just as concerningly, PE/PC is now pushing to
have products made available to retail investors through 401(K)s, potentially
leaving the most vulnerable as bag holders. We can only hope they fail and
regulators don’t loosen retail investor protections at precisely the wrong
time.
Nevertheless, despite all these efforts, new PE
fund commitments are falling, and a slow but steady souring in attitudes to PE/PC
is becoming an increasingly established trend, and it has been hastened not
just by the poor performance of PE since 2022, but also the strong performance
of listed equities and higher interest rates. It is now less necessary for
investors to “reach for yield” as there is more yield available in government
bonds and high-quality corporate debt instruments.
Given the amount of shenanigans that have been
going on, with little scrutiny/transparency or regulatory oversight, it is
perhaps unsurprising we have recently started to see cracks appearing in
private credit, and some investors taking seriously the risk this is just the
tip of the iceberg. In the past few months we have seen several major PE/PC
backed bankruptcies/frauds come to light, including First Brands, Tricolour,
and Bankim Brahmbhatt – the latter of which was a straight up fraud involving
falsified invoices that no one bothered to check the validity of.
These have raised questions about the degree of
due diligence being performed, and such lax oversight is a common symptom of
too much money chasing too few deals. Moreover, articles are cropping up about
the growing level of PC defaults and the alarming increase of the use of PIK (payment
in kind) – where interest is not received in cash but rolled back into loan
principal – a classic “extend and pretend” tactic shady lending institutions
have used for centuries, and is typically associated with borrower distress. Jamie
Dimon also pointed out that listed BDCs (business development companies), that
are essentially listed private credit entities, have been sharply selling off
of late – a further potential warning of sharp deterioration in their
underlying credit books.
What is notable is that these cracks are
appearing despite the economy being strong; the Fed cutting rates to levels that
are already quite low in real terms (c1%); credit spreads being historically
low; and with a booming stock market. One can only imagine how bad the
situation could be in a recession, with high real rates, or with a blow out in
credit spreads. It is not uncommon for bad lending practices and fraud to be
exposed on a scale that shocks people after the tide goes out, but the
tide is still very much in. That defaults are already rising is a potential
sign of a disturbing level of underlying excess.
It is also important to recognize how closely
intertwined private credit has become with private equity. Private credit is at
least as big of a problem as private equity, and potentially much worse and more
systemically risky. Private credit is the biggest lender to the private equity
industry, and this is not surprising given that PE and PC sponsors are
typically the same entities. Related party lending is likely rife. In a
downturn, they could each reflexively contribute to the other’s demise –
private equity defaults will lead to private credit losses and defaults (PC
funds are also leveraged, and likely cross leveraged with other PC funds). PC losses
will cut off new PC fund raising, which in turn could limit funds available for
PE refinancing, potentially triggering a PE credit crunch. Reduced availability
of financing, and at higher cost, could quickly cascade into yet more PE
defaults and PC losses. If you are heavily allocated to PE and PC and believe
them to be uncorrelated asset classes, you might want to think again.
The problem with analysing private credit is the
extremely low level of transparency. No one really knows who they are lending
to and on what terms. I have sat in on both PE and PC fund pitches, and found
the level of disclosure to be utterly appalling. You literally have no idea
what they are doing, what they own, how much leverage they have, the financial condition
of their underlying investments, or what valuation methodologies they are using
to value their assets. Its all “trust me bro”.
What ultimately happens remains to be seen, and
the extremely poor levels of transparency make it difficult make firm
predictions. But what is clear to me is that many if not most investors have
fundamentally misappraised the risk and return characteristics of these “asset
classes”. As Rasmussen points out, the way these funds have been marketed – as lower
risk, uncorrelated alternatives – stands in stark contrast to a sensible
analysis of the facts, and it is remarkable how credulous supposedly
sophisticated investors and allocators have been. In Rasmussen’s fabulous
words, the whole PE industry is essentially a giant exercise in “volatility
laundering”. While low volatility is a desirable trait for risk-averse
institutions, if the low volatility is entirely fictional and an artifact of
failing to mark-to-market positions, you are receiving no benefit other than
the capacity to delude yourself.
Private equity funds in fact own portfolios of
small and relatively low-quality businesses that were acquired in a competitive
bidding environment, are highly leveraged, and are held in extremely high fee, non-transparent,
and illiquid vehicles. The idea that such assets would be lower risk, less
volatile, and uncorrelated to listed equities/economic conditions, is patently
ridiculous. And yet as Rasmussen notes, if you look at the marks PE vehicles
are taking, the volatility they are reporting is more consistent with those of
high grade corporate credit instruments – utter fiction. He goes on to note
that listed private equity funds that exist in the UK, volatility is higher
than average, which is exactly what you would expect. They are also, unsurprisingly,
trading at a 30% discount to their stated NAVs.
It has taken a long time, but it seems the
pieces are potentially falling into place for the beginning of a major clean out of the
PE/PC industry, and in my view, a cleanse cannot come soon enough. I don’t know
what ultimately happens, but what is clear to me is that: (1) a tremendous
amount of risk has been taken by PE/PC investors who didn’t know what they were
signing up for; (2) the PE/PC industry is already starting to experience evident
strain, in their inability to market assets and fund distributions; the rising
tide of PC delinquencies and PIK; high profile defaults and exposures of fraud;
and greater fund raising challenges; (3) the lack of transparency, regulatory
oversight, and investor due diligence has allowed appallingly bad practices to
flourish unimpeded for a long time; and (4) PE mark-to-model return and volatility
accounting are fancifully optimistic at best and fraudulent at worst. Coupled
with extortionately high fees, all the ingredients are there for potentially very
bad outcomes for LPs. The only question is, what will the shape of the bust look
like – explosive and disastrous, or drawn out and benign? And what will the
systemic consequences be?
Disaster is not inevitable. The Fed could cut
rates back to zero and stocks could go to the moon, and provide the industry
with a bailout. The industry could succeed to pushing money into permanent
capital continuation funds, including via tapping retail investors. The
industry could grind/muddle through with low-mid-single digit returns – LPs will
experience disappointing return outcomes and have their money trapped for years
or even decades, but they might still eventually get their capital back. And a
systemic crisis/blow up might be avoided. But we could also see something much
worse.
The consequences
A bubble exists when (1) a wide divergence between
what people believe to be true and what the underlying economic reality is
emerges; (2) it manifests in market prices; and (3) those market prices have a
material impact on economic behaviour. On these criteria, we have a bubble in PE/PC.
The risk and return characteristics of these vehicles have been wildly
misappraised, and carrying values are hugely exaggerated. We have many institutions
and investors that believe they have more wealth and that it is less risky than
they actually do – my guess is the fair value of the combined US$5tr of assets
held in the US PE/PC industry is probably worth only about 60% of that in
reality – a US$2tr hole. And when that hole is exposed, it will change economic
behaviour, and likely to a noticeable degree.
However, not all bubbles that burst do so in a
rapid chaotic way that leads to a spiralling crisis. Sometimes the pain is simply
amortized over a long period of time. Does a PE/PC bubble’s unwind have the
capacity to be rapid, chaotic, and systemically destabilizing? For the most
part, probably not, though all the second order consequences can be
difficult to foresee.
Liquidity is fundamental to credit and other
financial crises – it’s not just about solvency. In order to have a “Minsky
Moment” that triggers a rapid spiral into crisis, you need to have liquidity structures
that enable fear to manifest in rapid and destabilizing liquidity withdrawals.
For example, if a bank goes bankrupt and fearful depositors rush to withdraw
deposits from banks, without an adequate “lender of last resort” response from
the central bank, the panic can quickly escalate into a major crisis. PE and PC
products are, by design, illiquid, and a “run” cannot happen. It is therefore
much more likely we have a slow-moving train wreck than a sudden blow-up. It is
more likely PE/PC investors are simply stuck in low returning paper they can’t
get out of for a long time.
However, that is not to say there will not be economic
consequences. As PC inflows dry up, the availability of new credit will
tighten, and a significant number of leveraged PE-backed businesses could be forced
into default by a lack of access to affordable refinancing (though PC is using
PIK deception to forestall that outcome for now). Secondary markets are starting
to developing in PE/PC funds that often feature sharp discounts, and at some
point auditors/administrators could force other LPs to take write-downs on alts
to match secondary market transactions. Some pension funds, endowments, insurance
companies, and HNW individuals, who have allocated as much as 40% to
alternatives, could find themselves with unexpected 20% holes in their balance
sheets, which could prompt a reduction in spending and higher savings rates in an
attempt at balance sheet repair.
In a bust scenario (cascading PE and PC
defaults), the banks will probably be ok. The vast majority of PE lending
exposure is in the shadow banks and particularly the PC industry. Since the
GFC, banks have become heavily regulated and risk averse, and are now well
capitalized and liquid. I imagine they will have some exposure, but I expect it
will be relatively modest and likely skewed towards higher quality borrowers,
tranches, and sponsors. Banks, which have lower funding costs, have also cherry
picked the lowest risk small businesses to lend to, leaving private credit to
lend to much higher risk borrowers at high rates. There will nevertheless
likely still be some losses amongst the banks, but they should be comfortably
absorbable.
The insurance industry, however, appears more
vulnerable, given, as noted, PE sponsors have been acquiring insurance
companies and using their investment books as dumping grounds for their toxic
waste. Even unaligned insurance companies though have often been as guilty as
pension funds and endowments in “reaching for yield” and over-allocating to alts
in an effort to compensate for lower interest rates – particularly during the
2010s. Insurers are leveraged and regulated institutions, and in a bust
scenario, I would not be surprised if at least one meaningful insurer needs to
be recapitalized as a result of large, unanticipated losses in PE/PC and other
structured credit products. I also think it is likely a regulation is
eventually put in place that bans financial sponsors from owning insurance
companies (ideally it should be done now, but it probably won’t be until after
a crisis occurs).
To be clear, PE/PC companies are putting peoples' life insurance and retirement savings at risk, sometimes through underhanded
means including shopping for inflated ratings. It is unconscionable behaviour and
represents everything Main Street hates about Wall Street – in this case
justifiably so. There may be some systemic risk here, and if you own insurers –
particularly life insurers with long dated liabilities, I’d be taking a hard
look at the size of their allocations to alternatives.
The overall size of the US PE & PC market is
about US$5tr. While that is large, it needs to be kept in the context of a
US$30tr overall US economy, US$50tr S&P 500, and the fact that the US
federal deficit is almost US$2tr a year. If the hit was all taken at once, it
would be systemic; however, as noted, the pain will likely be drawn out over
multiple years – a slow-moving train wreck rather than an explosion. In
addition, many of the losses will be absorbed by wealthy endowments, middle
eastern sovereign wealth funds, and HNW individuals/family offices that can
afford the hit. My base case expectation is no crisis – only very disappointing
return outcomes for PE/PC investors.
Nevertheless, PE/PC vulnerabilities are just one
of a menu of potential vulnerabilities in the global economy and global markets
right now, and history suggests that when it rains it can pour. In addition to
the PE/PC bubble (which also extends to a VC bubble as well), we have:
*A historic AI/tech bubble in listed equities.
The epicentre is the US but the phenomenon is now worldwide in this sector
specifically. I have written about the bubble and the potentially explosive
consequences of an AI bust recently.
*We also have record levels of government fiscal deficits and accumulated
debts. The US federal government is still running at 6% fiscal deficit and has
125% debt to GDP, and this is occurring not at the peak of a recession, but during
boomtimes. In a major recession, “automatic stabilizers” could see this deficit
quickly go to 9-10%. The UK has a 5% deficit, a stagnant and structurally
challenged economy, and more than 100% debt to GDP, and France has similar
challenges, with the added problem of lacking its own currency that it can
inflate/depreciate. These are already very highly taxed economies, and as the
Laffer Curve famously shows, at some point higher tax rates led to lower tax
receipts. The UK has already recently tried to raise taxes on the rich
including “non-doms”, which has backfired and triggered a mass exodus, such
that higher taxes on main street – previously categorically ruled out by Labour
before the last election – are now back on the table.
From here, it would not take that much to push
the UK, France, and the US into potential debt distress, necessitating fiscal
austerity that could radically worsen any pre-existing recession that were
pushing deficits towards breaking point. This is not a prediction, simply an
acknowledgement of the risks and vulnerabilities that are building up. History
shows that, while rare, crises do on occasion happen if the stars align. The
uber bear scenario would be all three of these things exploding at once – an AI
bust; and a sovereign cum generalized debt crisis that forces fiscal austerity
while blowing out credit spreads that takes down the whole leveraged asset
complex, and particularly PE/PC.
While as noted, full blown crises are rare,
there are definitely key points of vulnerability that bear watching. Much more
likely though is we simply have a phased blow up of PE/PC over a decade, which
hurts those involved and discredits many institutions, but does not escalate to
anything systemic. But hey, anything could happen.
A final thought
A final thought/aside, is how extraordinary it
is to observe the widespread groupthink and lack of critical thinking that has led
to a major cross section of the world’s supposedly most sophisticated
investors, allocators, intermediaries and institutions sleepwalking into enormous
overallocations to PC/PE instruments that are illiquid, high fee, and non-transparent,
and doing so with an almost total lack of any critical thinking or even basic
investment analysis. It is a damning indictment on the industry.
No matter how many times it backfires, asset
allocators seem to have an incurable tendency to just look at the trailing reported
returns and volatility characteristics of an asset, apply basic (and flawed)
quantitative tools much as Sharp ratios, and believe they are making
intelligent value-add decisions. That approach is not good enough. Markets are
complex and you have to understand how the returns are being generated
(and the risks attached to them) – you have to understand the complex realities
that lie behind the numbers. Else, you will make the same idiot mistakes as everyone
else makes and at the same time. And you will believe things that are too good
to be true.
The idea that you could get the best of both
worlds – high returns without any risk/volatility – and without any catch or
need for sceptical due diligence, and in high fee products no less, is rank amateur
behaviour. Any idiot can see on paper that Bernie Madoff’s returns are high
and downside volatility limited. The wise investors asks how that is possible,
and demands to know how the money is being made before simply handing buckets
of it over. It is only one step removed from unsophisticated retail investors
buying into Ponzi schemes that promise 20% returns a week. The world deserves better.
LT3000
