Is the party over for private equity?

June 16, 2022 at 09:05 am EDT

Could it be that the tide is turning for private equity, the "star" asset class of the last two decades? Scalded by the volatility and the number of frauds in the so-called public markets, i.e. the equity markets, investors have been flocking to the private markets since the beginning of the century, enticed by the promise of returns as high as those of equities but without the risks traditionally attached to them.

Recent news has provided some examples of adverse signals for the sector. We learned that the American FTC intends to stick its nose into this juicy business. For his part, Amundi's investment manager, Vincent Mortier, said in the Financial Times that some parts of "PE" look like a Ponzi scheme. However, these headwinds seem anecdotal when compared to the amount of funds collected, which has been breaking records year after year. “You know you can sell [assets] to another private equity firm for 20 or 30 times earnings. That’s why you can talk about a Ponzi. It’s a circular thing,” he said. Obviously, a fairly sharp rise in interest rates would have an impact on the sector, as cheap money has been a major factor in driving investors into private equity.

The shift in the monetary paradigm provides the main arguments for the industry's critics. A rise in interest rates could lead to a real bloodbath in the PE industry, as it is mostly exposed to direct financing with a sometimes unreasonable approach to risk, which consists of lending with minimal risk premiums to small or medium-sized companies that are already highly leveraged. Historically, no one in their right mind would have lent capital to a heavily indebted or second-rate borrower on these terms. The ongoing mechanics that should lead to a return to economic rationality do not really bode well for the sector.

The fundamental problem with PE is that it is an industry that favors managers over investors. It is therefore not really surprising that all asset management entrepreneurs have jumped on board. The main characteristic of PE is that the manager locks in the investor's capital for a long period of time, typically a 5-year mandate, which, unless there is a severe setback, is renewed at least once. The manager is therefore left with a more or less guaranteed fee over the long term. To put it in perspective, for a mandate of €100 million at 1.5% per year, €15 million will be paid out over ten years. This is the best incentive to multiply collections, even if it means deploying them at all costs in anything.

But for what real performance? This is where the great ambiguity lies. Because the instruments are private and are not traded on a free and transparent market, their value is subject to various discretionary but all too often partisan and therefore self-serving evaluations. Either it is the PE firm that does it itself, or it is external service providers whose commercial interest is to serve their clients (i.e. PE funds) well in order to obtain more mandates... A bit like in auditing, they are so dependent on their clients that the relationship becomes almost incestuous. So, to put it mildly, this is a business where you measure your own performance and where you are guaranteed gargantuan management fees over time.

Race for size

This system of "fees" results in an intrinsically flawed incentive system: the manager's interest is not so much to make quality investments as to maximize the number of assets under management. The higher the assets under management, the higher the compensation. Thus, many PE stars actually have more of a capital deployment problem than an investment selection problem. "The reality is that they often put their clients' money into everything that comes along, to lock in the mandate and secure the fees. And then who will live to see. In any case, everyone does the same thing", underlines this good connoisseur of the sector. And if there is a problem somewhere, you can always blame the government, the economy, the Fed or your neighbor.

Vincent Mortier, Amundi's investment director, is right to point out that the industry is increasingly resembling a Ponzi scheme, with firms selling their assets to each other, often without regard for fundamentals, but with a pure logic of profit-sharing and predation. To make matters worse, part of the remuneration is linked to performance fees indexed to criteria such as revenue growth or metrics that can be manipulated at will, such as "adjusted" EBITDA, which has been so popular for the last twenty years. All of this encourages "build up", the race for size through growth strategies that are not necessarily reasonable. This is why funds load companies with debt to pursue risky and barely profitable M&A strategies... In doing so, they improve the size and the "adjusted" Ebitda and get commissions in the process. In this logic, many players are ready to buy or sell anything, even if it means not really making money... but with the collections swelling, they still distribute to their first investors. In this sense, the scheme tends to be a Ponzi scheme.

So this industry certainly generates a lot of excess. Of course, there are good operators. But it becomes very difficult to keep a cool head when faced with the possibilities of enrichment, especially in an environment dominated by the animal instinct of trying to collect more than the neighbor, for all the reasons mentioned above. The funny thing is that the market is so saturated that PE boxes are selling assets to each other at a high price. The price to pay to avoid killing the goose that lays the golden eggs.