Public problems for private equity

0:05Pushkin. Private equity. It's been one of the best returning asset classes of the past, call it 20, 30 years. It's wormed its way into pretty much every institutional investor's portfolio, and it's generated a fair amount of political controversy along the way. But today on the show, investors are starting to wonder, can private equity keep it up? This is Unhedged, the markets and finance show from the Financial Times and Pushkin. I, reporter Ethan Wu, here in the New York studio, joined today by anti-PE ODB, Robert Armstrong. Yo. Do you want to define ODB for the listener? No, I do not. Okay, moving swiftly on then.

0:48The reason we're talking about this now, right, PE's been in the ether for a long time, but I think it's increasingly getting more coverage because investors are looking at some of PE's evolving tactics and saying, you guys are looking a little desperate. So our colleague, Antoine Gara, has been reporting for a while now on the fact that private equity funds are turning to, or if you prefer, resorting to increasingly exotic forms of debt financing to keep their portfolio companies going. So I think a lot of us investors, people in the press are looking on and saying, we remember that old story about how private equity funds bought companies and made them better.

1:34But now you're doing these sort of financial engineering card tricks. And we're wondering if there is something unfortunate going on behind the scenes. Yeah, yeah. And we'll get into all this in more detail because there's a reason that they're getting into these financial engineering tactics. But I think before that, we need to start with what is PE? Most of the time we're talking about leverage buyouts. I am a private equity smarty pants. I have a large pile of institutional money. I take a part of that pile and I buy a company outright. Now, the most important feature of this purchase is that I actually don't use that much of my pile of money.

2:19Most of the purchase is paid for by borrowing a lot of money, either from a bank or the bond market or somewhere else. So I own the company in much the way that most Americans own their houses at first, with a tiny little slice of equity or actual ownership and a big old mortgage on top of that. Yes. And I think one part of this that does generate controversy is the debt ultimately ends up held by the company in a lot of cases, not necessarily the private equity firm itself. This is the classic criticism of private equity, that they pile a huge amount of wicked debt onto virtuous and hardworking little companies.

3:06And if the companies happen to go bankrupt, because of this immense pile of debt, the private equity executives simply walk away rubbing their hands together and cackling like movie villains. I'm not sure that that criticism is particularly fair, but it gets at something important about the economics. Yeah. I'm glad you brought up that homeowner metaphor because I think that brings us from a description of what is PE, borrow money to buy a company, put simply, to what is the water PE has been swimming in in the past decade, two decades or so. And with a homeowner, you would like to be in the housing market if rates are low and falling and your asset price that you've borrowed to purchase is going up.

3:50You feel great. You feel like a genius. This, I think, is not too dissimilar from how it's been for private equity in the somewhat recent past. It was a pretty good environment to be in. And now the great time is over. Yes. Just as it is for a homeowner who is discovering that mortgage rates can actually go two directions. So private equity is discovering that general interest rates, cost of borrowing can go up, which not only makes your debt more expensive if you haven't termed it out to the infinite future, it also increases the probability that your asset value is going to fall. Yeah. So a lot of the favorable aspects of the environment that PE enjoyed for so long are disappearing.

4:36And there's another point to make, actually, that actually predates the point about the changing rate environment, which is a changing competitive environment. Yeah. So in the early days of PE, going back even to like the 80s and barbarians at the gate and the Nabisco buyout. Which was like the original kind of foundational LBO that put private equity on the map. Yeah. Everybody's like, whoa, you can buy a big company. Yeah. These corporate raiders are really serious. And early on, there was a lot more, to use a somewhat tired metaphor, low hanging fruit. Yeah. In terms of companies that were out there to buy, either poorly managed and inefficient public companies or small private companies, smaller private companies that didn't sort of know their own value.

5:25But as private equity has enjoyed tremendous success, more and more money has flowed into the industry. The number of private equity firms have proliferated and the competition for assets has gone totally bananas. So even before the interest rate environment changed, we were seeing private equity returns fall because they were having to pay more money in a more competitive industry environment to buy assets in the first place. And now it feels like there's almost a bit of a hangover for PE where deals have come down a lot from maybe 2021 or so. The cost of funding is massively higher, as we've talked about many times on the show, with interest rates at five plus percent.

6:07And now there are anxieties, I would say, among investors about some of the emerging tactics in the PE industry. One of these tactics is new and aggressive forms of borrowing. So we mentioned at the top of the show, classically, your private equity borrowing is happening at the company level, right? The company they own gets a bunch of debt put onto their balance sheet. Increasingly, what is happening is the private equity funds, right? The ownership vehicles for these companies are themselves taking on debt. And that has a lot of investors concerned. Are we going to get these 15, 20 % returns if there's borrowing on the fund level?

6:47Because if there are defaults on the companies, which we're seeing nationwide, a slow but steady increase in the default rate. If there are defaults of these companies and the fund itself has borrowed money, that could really, really hurt returns because that money has to be paid back. And the reason they're borrowing at the fund level and in other creative ways is they can get cheaper debt that way in an environment where bog standard debt isn't as cheap as it once was. Like if you have a company that's struggling a little bit and that company needs to borrow yet more money to keep going, a private equity owned company, then the price of that money, that's going to be like money that is in the teens at an interest rate.

7:28whereas if the whole fund, essentially all the companies in the fund and all its investors borrow the money, you're going to get a much better rate. This is such a good point. It's all part and parcel of this higher rate environment. Rates went up, so there's more kind of default pressure and profits pressure on the underlying companies. And because the cost of funding is higher if you're borrowing at the company level, there's this incentive to borrow at the fund level because you can get cheapness from borrowing at that scale. The fund is much bigger than any individual company. And of course, the change in the asset price environment is implicated as well.

8:01Why do these little companies owned by PE or these medium-sized big companies owned by PE need to borrow more money? Because the PE fund does not want to sell them right now because they don't think they would get a good price. Either the business's operations are struggling or the environment for an IPO or for a sale to someone else in the industry isn't as good as it once was. At the headquarters of the PE fund, they're like, well, maybe in six months, things will be better or in a year, things will be better. We can prop this thing up, inject a little more capital, and maybe the sun will come out tomorrow.

8:38The problem with that is sometimes the sun doesn't come out tomorrow, number one. And number two, the longer the private equity fund holds an asset, the lower its returns are likely to be, right? They're dividing the total increase in value of the company by a larger number of years. So what they call the internal rate of return sinks the longer you own the thing. So that's a picture, broadly speaking, of it's getting harder, not necessarily like financial crisis, right? But it's getting harder to be a private equity firm that churns out those 15 % or 20 % returns. This all helps explain some of the tidbits that are popping up in reporting like our colleague Antoine's.

9:17He has in his piece yesterday that large investors in PE funds are like checking the fine print of the contracts to see if they can rein in some of this financial engineering activity because I think they're nervous. Are we going to get those 15 to 20 percent returns anymore? It's an old story in private equity that when things do go sideways, the creditors on the deals rather than the equity holders of the deals tend to take the most pain. The private equity funds were orders of magnitude more clever in the writing of contracts and the deployment of fancy lawyers. I think that's changing. The credit investors in the deals, who are often private equity investors wearing a different hat at this point, are getting much more sophisticated.

10:03And so private equity is there. Gosh, the returns on this deal isn't that good. Maybe I need to inject more money in the company so I can buy more time, so I can hope the company recovers and I can sell it at a better price in a more favorable market. And the credit investors are sitting there like, whoa, whoa, whoa. I was comfortable with a certain amount of debt on this company, maybe not a little bit more. And now you're changing the deal slightly on me. And it just tells you something about the changing environment in the industry in general. Yeah. It used to be that private equity had the lawyers with the shiniest suit and best, most slicked back hair.

10:43And that's changing. A lot of these companies now have all kinds of very sophisticated people taking a look at how they can get the most money. And someone has to lose at the end of the day. There's not infinite money in these companies to kind of extract, right? But, Rob, we've spent a lot of time walking through, you know, changing competitive dynamics that make it harder for PE investors to make money. Should institutional investors, your pension funds, your university endowments, should they be in this asset class anymore, do you think? I think they probably should be and they certainly will be for some reasons that are a little bit surprising but worth rehearsing.

11:19You and I probably agree that returns from private equity over the next year or two are going to fall and look more like your average asset class. It's going to look a lot more like owning stocks or owning high yield bonds or whatever. Maybe a little higher because of the higher leverage but returns are going to be more average. One very important positive characteristic that private equity will retain, even when its returns inevitably revert to the mean, is that it is not marked to market. That is the private equity investment sitting on CalPERS balance sheet or the Ottawa Teachers Union pension fund balance sheet or whatever.

12:05That is very stable because the price of the asset doesn't get updated very often. And the update is sort of under the control of the private equity company. Yeah. And for slightly obscure mathematical reasons I won't go into right now, the very stability of those returns increases the overall risk-adjusted returns of the total portfolio of the investors over time. So just the math gives a reassuring, an appealing aspect to private equity investment. Acute listeners will notice that there is a slight flavor of the absurd to all of this, that this asset class is valued more highly because you know less about its true underlying value, which is the exact opposite of what you'd expect.

13:01But nobody said the world wasn't weird. Yep. It turns out investors will pay more for a line that goes up and down less as long as it goes up. As long as it goes up. All right, Rob, we'll be back in a moment with Long Short.

13:20Welcome back. This is Long Short, that part of the show where we go long a thing we love and short a thing we hate. Rob, I'm feeling along the dollar. It's very entrenched as the most powerful currency in the world. And I don't really see a strong reason why it won't be in the foreseeable future. We wrote about this today on the Unhedged Newsletter with Columbia historian Adam Tooze. And even Tooze, who I think has some interesting points on the margins, he wasn't really willing to go after that argument that the dollar is going to stay dominant. All the arguments I've seen, I think, have left me skeptical of the critics of the dollar.

13:53The dollar just seems very much entrenched. The US dollar is the Microsoft operating system or the Google search engine of the global economy. Yeah. Everybody uses it, so it's easier just to keep using it. And that is on top of the fact that America is very big and rich and solid. Yeah. Yeah. A lot of reasons to hold the dollar. Rob, are you feeling short something? I am short Birkenstock stock. Katie Martin's not here to defend. I know. The IPO is a success in that it raised a lot of money for the company. It was a failure in the sense that the price immediately fell when it got into the hands of the public.

14:34It's off again today after being down a lot yesterday. I think what the market is sniffing out is that this is a company that was optimized by private equity to look very good when it IPO'd. They are in the midst of a tricky new retail strategy. They are raising their prices and the shoe itself is at the peak of its fashionability. So I fearlessly predict that Katie Martin's loyalty to these atrocious looking shoes will not be enough to get the stock price to bounce from its current sorry position. You know, at the end of the day, if you end up being right about that, that might be good news for Katie Martin because if they're unprofitable and they start losing customers, peak of the fashionability, maybe they got to cut prices.

15:22Right on. I don't know. That's the miracle of capitalism. For Katie's sake, let's hope that turns out to be true. All right, Rob, thanks for being here. We'll have you back soon. And listeners, we'll be back in your feed on Tuesday with Katie Barton for another episode of Unhedged. Catch you then. Unhedged is produced by Jay Carver and edited by Brian Erstad. Our executive producer is Jacob Goldstein. We had additional help from Topher Forges. Cheryl Brumley is the FT's global head of audio. Special thanks to Laura Clark, Alistair Mackey, Jacob Weisberg, and Jess Trulia. FT Premium subscribers can get the Unhedged newsletter for free.

15:59A 30-day free trial is available to everyone else. Just go to ft.com slash unhedged offer. I'm Ethan Wu. Thanks for listening.

16:25Thank you.