The Day of Reckoning for Private Equity

This article originally appeared here in Institutional Investor on April 16, 2020

The Day of Reckoning
for Private Equity

This crisis is likely to mark the apex of private equity – irrespective of how the drama around accessing government loans plays out.

April 16, 2020

Illustration by Jeremy Leung/II
Illustration by Jeremy Leung/II

The Global Financial Crisis catalyzed a fundamental change in the hedge fund industry. 

Caught in the crossfire of a financial system fraught with risk, hedge fund returns suffered and clients rushed to redeem. Hedge fund managers faced frozen credit markets and had to decide whether to sell illiquid assets to meet redemption requests. Some did – and became proverbial ATM machines. Others closed gates intended to prevent this exact type of forced selling. It was the beginning of a mess that forever changed that industry.

It’s now private equity’s turn.

Private equity has basked in a decade of sunlight, boosted by a robust economy and ultra-low interest rates. While active management in the public markets battled withdrawals and fee compression, private equity managers escaped scrutiny and generated returns. Massive fund commitments followed. 

Then came the virus.

The Covid-19 crisis is creating a challenge for private equity firms akin to what hedge funds tackled following 2008. Like hedge funds navigating a shock to the financial system, private equity has no easy solution to a shock to the economy. The sudden stop turned a laser-like focus on corporate liquidity and indebtedness. Those that make it to the other side of this pernicious pandemic can prosper; those that don’t face bankruptcy. 

No set of companies across industries is more at risk than those owned by private equity firms. Leveraged buyouts – now euphemistically called private equity – have “leverage” in their name for a reason. That financial tool works both ways, magnifying returns in good times and punishing results for equity holders when the tide turns.

Amid a depression of unknowable duration, the government is coming to the rescue. Companies staring into the bankruptcy abyss have an option to stay alive with rescue financing. The CARES Act will provide a massive backstop to ensure companies can stay afloat. 

This sequence of events poses a question that may determine the fate of private equity firms for years to come:  Should private equity-funded companies access government loan programs?

Steve Nelson, the CEO of ILPA, wrote a letter urging the U.S. Treasury and Federal Reserve to include private equity-owned firms in CARES loans. Jim Vos, CEO of alternatives consultant Aksia, similarly believes private equity companies should have access to government funding. Vos warned in a note to managers that taking advantage of SBA loans for themselves, however, would have severe consequences for their reputation. 

Neither pointed to the potential negative ramifications of the public’s perception of private equity firms that deploy government loans. On their side, private equity-backed businesses are the new ‘too big to fail’. Together, they comprise 35,000 companies, 1 million employees, and 5% of GDP. Their clients include substantial pension funds, whose beneficiaries need support today and in the future. In this unprecedented time, companies need saving – irrespective of their owner. 

On the other hand, private equity firms have a $1.5 trillion war chest of capital to cure the balance sheet problems they created. Leverage deployed by private equity has put portfolio companies in astonishingly poor financial standing. Seventy percent of all private equity-owned businesses have debt rated below investment grade, and 80% of all companies rated B3 are backed by private equity. Surely, some of the outstanding capital commitments can shore up balance sheets just as easily as low-interest loans from the government. 

Further, enrichening the wealthy in the process won’t look good for the industry. Although pension clients would benefit from private equity managers tapping into government loans, managers take a nice paycheck in the transmission of gains to their clients. The financial services industry lost a public relations war in the aftermath of the GFC for this very reason. It won’t end well for private equity this time around. 

This crisis is likely to mark the apex of private equity, irrespective of how the drama around accessing government loans plays out. When the dust settles, we will see a reduction of leverage on balance sheets, either by regulation or the actions of private equity managers. We will see lower economic growth. We will see higher rates of interest. And we will see lower returns from private equity.  

Hedge funds survived the GFC, but the glory days of the industry ended. Fees compressed, the industry bifurcated into the mighty and minnows, new entrants faced uphill battles, and investment boards shifted from wanting more hedge funds to eliminating the words “hedge fund” from their agenda. 

Private equity will survive this crisis. No less than the Yale University endowment’s David Swensen has referred to private equity as the epitome of capitalism: It compels long-term investing, enables financial flexibility, and activates control over operations. It’s not just employing financial leverage that drives private equity returns.

At the same time, the going has been good for so long that the future looks murkier than the past.  Purchase prices are elevated, leverage can cause pain, and returns are likely to fall short of investor expectations through this period.  

Two years ago, I suggested that private equity managers will be scrutinized for their behavior by investors down the road. How private equity managers conduct themselves through this period may prove one of the key attributes that determines their future. The time has come for scrutiny on private equity managers whose behavior serves their own interest first. After all, every CIO I have interviewed on the Capital Allocator podcast speaks of the quality of people as foremost on their mind when making manager selection decisions.

GPs beware: Allocators are watching.