Commentary: The private equity bubble is bound to burst
The private equity bubble may be threatening a segment of the global economy — with potentially more serious consequences, says Financial Times' Patrick Jenkins.
LONDON: Blame Brexit jitters. Blame tax tweaks. The average London home at the end of last month was worth 5 per cent less than it was two years ago, according to insurance company Nationwide.
If you happened to buy UK property with a 95 per cent mortgage, you’ll be on the cusp of negative equity.
Back in the early 1990s, that dynamic spread horribly, leaving some with big losses and trapping others in unsaleable homes. A generation of zombie homebuyers caused chaos for years.
PRIVATE EQUITY IN TROUBLE
Few commentators today are forecasting an imminent housing crash. But something similar may be threatening a segment of the global economy — with potentially more serious consequences.
The UK high street is under pressure from all sides — rampant online competition, higher rents and rates and a failure to modernise are all to blame.
But for many businesses, it has been the burden of high-yield debt, often issued as a consequence of private equity ownership, that has been their undoing.
The latest casualties have been restaurant chains. PizzaExpress, Byron, Zizzi — name a chain and the chances are it has overexpanded and struggled under private equity ownership.
Earlier, buyout groups had focused on high-street retailers. The demise this week of Debenhams is a reminder of the long-term damage that aggressive private equity ownership can wreak.
Barely three years in the hands of CVC, TPG and Merrill Lynch a decade and a half ago left the business with pricey property leases after the owners sold off freehold shops, and debt leapt 2,000 per cent higher to £1.9 billion (US$2.5 billion).
It never recovered. Last year Toys R Us, owned by KKR and Bain Capital, failed for similar reasons with the loss of 30,000 jobs.
A SLUMP IN CHINA
More recently, and more worryingly for those who believe canaries serve a useful purpose in coal mines, China has revealed a dramatic slump in its nascent private equity market. Fundraising by yuan-denominated buyout groups collapsed 86 per cent to US$13 billion last year.
In the broader context, these are barely audible chirps. The global private equity market, worth more than US$5 trillion at the last count, has been on a tear since soon after the 2008 crisis.
Its business model of buying up companies, cutting costs, adding debt and selling five or six years later has delivered juicy returns.
The sector has received a twin boost from the ultra-low interest rates of the post-crisis years: They made debt cheap and lured investors desperate for higher returns than are available from listed securities.
In recent years, it has generated an average return of 17 per cent, compared with last year’s negative 4.4 per cent for the S&P 500 and a negative 8.7 per cent for the FTSE 100.
VICTIM OF ITS SUCCESS
But there are growing signs that private equity is becoming a victim of its own success.
So many pension funds, mutual funds, sovereign wealth funds and other yield-hungry investors want a piece of the action that private equity firms now have far more money than they know what to do with.
The sector as a whole boasts an estimated US$2 trillion of “dry powder” — funds that have been raised but have yet to be used for acquisitions.
As macroeconomic concerns have mounted, many firms are now chasing a restricted array of deals in sectors deemed more resilient.
In a sign of desperate competition, Scout24, a German online advertising group, was recently sold back to the buyout firm that floated it in 2015, at a 50 per cent premium.
At the same time private equity buyers are borrowing record sums to support their deals. Average leverage multiples — the amount of debt relative to profits — now top six times. And alarmingly, already high headline leverage numbers disguise real figures that are even higher.
It used to be standard buyout practice to make “adjustments” to profits at the time of purchase to reflect expected savings that might be made.
Now, some executives admit, it has become almost standard practice to include all projected savings over five years, so that the profit number used to calculate the leverage multiple is inflated by up to 35 per cent, rather than the 5 to 10 per cent tweaks common in the past.
Average leverage multiples, one financier says, are therefore in reality more like nine times rather than six. Cheating rarely ends well.
HOW BAD WILL IT BE?
The private equity bubble is bound to burst. The question is: How bad will the consequences be?
Thanks to post-crisis regulation, banks are less exposed to buyout debt, with loans now spread across other financial groups, including vast debt funds owned by private equity firms and other vehicles in which banks and asset managers invest. That may mean risk is diversified, or it could just mean the fallout hurts everyone.
With little sign of higher interest rates adding to the pressure on borrowers, this may not be the biggest economic risk. Instead, it may all come back to that mortgage analogy.
If recession forecasts materialise, even in the still booming US, overpriced, overleveraged private equity acquisitions could quickly tip into negative equity. A rash of zombie companies would result.
However good zombies might be at eating human flesh, they are bad at investing and creating jobs.