A recent Financial Times article on the plight of private equity in an era of high interest rates It contains a number of amusingly coded confessions of anti-profiteering, and before we get to the industry’s new clever ploy – of pushing companies onto the new fools: their employees – let’s look at some of the arguments about how hard it is to be a private equity leader when the Fed is no longer backing you.
The opening quibble is a myth that private equity funds can’t sell the companies they own.
Rising interest rates and a sluggish new listing market have made it harder for investors to sell holdings and return cash to them. That leaves pension funds, endowments and family offices with less money to allocate and more options, making it harder to raise new capital.
The people running these funds and their investors are likely familiar with investing: The first principle of finance is that every problem can be solved by price. The problem here is not that these companies can’t be sold, but that their private equity masters don’t like the prices they would get.
A related issue, which may not be obvious to many readers, is that large private equity investors, such as public pension funds, have historically expected, and have done, that private equity funds would return their capital fairly quickly. Historically, there has only been about four to five years between the time they recouped their investment and the time the private equity firm would sell a significant portion of the capital they purchased by the fourth or fifth year to facilitate raising new capital. These investors need to put their money to work, so when they receive distributions, they need to reinvest them, and with nearly all investors having high and growing allocations to private equity, they need to put a large portion of their money back into the private equity fund.
Having money tied up in old deals is bad for the industry’s economics. Private equity fund managers receive higher management fees in the early years of their funds as compensation for their efforts in acquiring companies. They also collect high transaction fees for courting the Wall Street giants to execute the deals, and usually also a fundraising fee for lining up the debt. So there’s a frenzy for new ways to dispose of, or at least partially dispose of, companies that no one will buy at the price the private equity moguls want to achieve. Here’s another quote from the article:
One sign that the squeeze is starting is Blackstone, the largest and best-known private equity firm, recently announced that it will launch a “co-ownership initiative” to grant equity to employees of its portfolio companies. The program will begin with Copeland, which Blackstone acquired last year for $14 billion. When the HVAC group is eventually sold, the company’s 18,000 employees will receive payments tied to the profits of the PE firm’s deal…
Ownership Works has helped 88 companies create nearly $400 million in employee stock ownership plans, with a goal of $20 billion within 10 years.
For private equity firms struggling to attract new investors, such schemes have a number of appealing features: First, PE sponsors can claim they are helping to reduce social inequality.
These arguments are likely to resonate with investors concerned about the role of private equity in returning most of the productivity gains to investors rather than workers over the past few decades.
Hmm. For those who have heard stories of growing wealth at the top, the way to share the benefits of increased productivity with workers is to raise wages, not to give workers less than they should receive and give them shares or stock chits at valuations above the fair market value of the company.
Certainly, employee ownership plans can be very motivating and productive if employees actually own the company, rather than just going with the flow as they do here. But even then, proponents of employee ownership plans would warn that they can pose dangers to the employee-investors’ financial situation. Employees are already heavily invested in the fate of the company by virtue of working there. If a disaster such as an explosion occurs at a major business location, employees could suffer significant pay cuts or even lose their jobs. The risks are heightened if you have some or a lot of your net worth invested in the company.
The article then goes on to discuss how private equity firms are not well-adapted to frugal living in the current high interest rate environment.
Rising interest rates have fundamentally changed the landscape for private equity firms, forcing them to rethink how they do business: Between 2010 and 2021, borrowing accounted for half of all PE results, according to consultancy StepStone.
With less leverage, private-equity firms have to find other ways to make higher returns, even as investors demand better results because comparable risk-free rates are much higher. “You have to do things differently going forward,” says Amit Garg, a senior partner at McKinsey. “The question is, how?”
The obvious path to lasting profits is through operational changes that increase revenue, reduce costs, or both. PE firms have always claimed to be doing this, but leverage has prevented some from putting in as much effort as they should.
This would be laughable, except for the fact that private equity has done so much damage by pretending to have better operational mousetraps, but mostly by simply plundering companies while not ruining too many of them.
We expect that some observers will argue, as we do, that private equity seems to deliver improved performance at smaller deal sizes, and that it typically buys companies with less debt than larger acquisitions. But insiders point out that this doesn’t necessarily mean that private equity bid management has delivered good performance. Rather, they argue that some private equity buyers are good at identifying “growth” companies, well-positioned companies in sectors that are likely to outperform, and acquiring them at the right price.
Consider the following section of this article.
A tried-and-true method is improved management. Some PE firms focus on appointing new talent to the boards and management teams of their newly acquired portfolio companies. Others maintain a staff of dedicated in-house consultants who service multiple companies. A third method is to hire veteran executives to advise company leaders.
At Goldman Sachs’ private equity division, experts from its Value Accelerator department advise on everything from finding the right headhunters and consultants to upgrading IT platforms and redesigning management processes.
Please help. These “proven methods” have been around for decades, yet the article effectively admits that they don’t bring the necessary profits. The author does not know or acknowledge that “in-house consultants” like KKR Capstone are just another way to extract fees from private equity firms. These services are billed to portfolio companies, and the consulting firms/accelerators are just another profit center in the private equity firm empire.
I was pleased to see that most of the comments on this article were critical of private equity. This is a stark difference from a few years ago, when skeptics (including journalists at the Financial Times) were portrayed as jealous haters. Here are a few examples:
alias
What’s infuriating is that the same institutional investors who complain about ESG are also investing in private equity, all despite private equity’s dismal track record of destroying companies’ long-term prospects through high leverage and one-sided management structures, increasing market concentration in the U.S. healthcare sector and other areas, undermining the quality of services for elderly nursing home residents, low-income residents and other vulnerable and disadvantaged groups, mistreating workers, and increasing wealth and income inequality through special tax benefits obtained and maintained through intense “lobbying” (also known as corrupting the political process).Despite this track record, hypocritical institutions seeking to “do good while making profits” through ESG are spending huge amounts of their portfolios on investments that have disastrous effects on society, undermine good and transparent corporate governance, and contribute to the corruption of national governments.
Thomas Rainsborough
The PE industry has some tough problems to solve.They have grossly over-allocated assets, and the asset owners who have done this are performance followers from the zero interest rate era, and they will get the returns that performance followers normally get. They are also now too large for the exit market, interest rates have normalized, and the leveraged returns that are PE are declining. The IPO market has not recovered because passive investing has reduced active cash flows in the public markets, and PE are viewed as terrible sellers given their track record of failed listings. Real companies with shareholders do not like to buy from them because PE are viewed as poor owners who will suck out future value. PE holding value based on public comparisons is an illusion. So they are playing a rights passing game between themselves and a few huge LPs. That is what is happening.
Parasol
Wow, so now they can’t even sell that junk and are forcing it on their employees, no doubt in lieu of a paycheck…Will employees’ families be able to eat the shares they are given?
This is oddly reminiscent of the collapse of the Soviet Union, when workers were given commodities to buy food from the factories they worked in, rather than cash, and so had to sell the goods they produced on the street to get food.
Shawn Corey Carter
The “retailization” of PE, finally allowing privately owned companies to join the party through accessible funds and IPOs from PE houses (sorry, asset managers), is surely a strong sign that things will fall apart as the general public will be the last to take responsibility after everyone else has disappeared with their (our) money.Small investors would be hurt, of course, but so would the careers of hundreds of thousands of people who, as wage slaves, are part of the machine but who don’t actually benefit from it.
One reader wondered whether any buyers would be interested in acquiring a company with such a large amount of employee ownership. Here’s the response:
Horsefellow
I work for a PE backed firm that has these schemes in place and you’ll be happy to hear that they give us literally zero control over anything.
One advantage of the Fed’s ruthlessness towards inflation is that it is not in a position to control the collateral damage to private equity, but the industry went through a period of decline after the leveraged buyout crisis of the late 1980s (luckily for them, in the shadow of the S&L crisis) and bounced back, so even if we could hope that the industry would shrink like crap, it could come back with a vengeance like a lamprey.
