Private Equity: The Biggest Loser from the Coronavirus Crisis?
But outside of those, how much damage will there be in other sectors?
This downturn is odd because many industries have been destroyed, others have stayed about the same, and a few have benefited.
But job losses rarely give you the full story, especially in industries with relatively low headcounts.
One example is private equity (the normal kind, not distressed), which directly employs relatively few people.
Despite that, most of the PE industry could be in for a tough period, and it will probably be less appealing if/when the crisis ends.
That’s because government actions have propped up asset prices while doing nothing to help struggling portfolio companies.
Normally, firms want to acquire fundamentally solid businesses at bargain prices – but the current situation is the exact opposite of that:
The Typical Arguments in Favor of Private Equity
When this crisis began, sites like Vanity Fair published articles declaring that “private equity is winning the coronavirus crisis.”
They argued that PE was “too big to fail” and that, like the big banks after 2008, it would emerge victorious but with more regulations and restrictions, such as the end of the tax loophole on carried interest.
I also heard from many readers who thought the industry would come out ahead because:
- Firms have so much “dry powder!” They’re up to $1.5 trillion in unspent cash, so they’re perfectly positioned to take advantage of a recession/depression.
- Private equity is a “long-term” asset class, so an economic catastrophe in one year won’t make a difference to performance over 5-10 years.
- And in the worst-case scenario, PE firms can just make a few “capital calls” and ask their Limited Partners (LPs) for additional funds.
However, I’m skeptical of all these points:
Point 1: Why “Dry Powder” Doesn’t Necessarily Help in This Crisis
“Dry powder” is useful if prices have fallen significantly, while business fundamentals have taken only a minor hit.
For example, it was helpful in the 2001 – 2003 and 2008 – 2009 periods because equity markets fell significantly, and many industries declined – but not catastrophically so.
That meant that PE firms could find solid companies at bargain prices and ride out the recovery.
This time around, prices haven’t fallen nearly as much due to massive intervention from the Fed and other central banks.
The S&P 500 dropped almost 35%, but then rebounded, and now we’re back to early 2019 levels.
Sure, it has been propped up by Big Tech, but even companies like Disney that should be devastated are not down that much.
The only companies that are still down significantly are ones like airlines that will have to restructure or liquidate.
Even in the credit markets, prices haven’t fallen that much because of the Fed’s promise to buy every asset imaginable (take a look at the chart for VCLT).
On a recent podcast, Howard Marks from Oaktree even said, “I wish the Fed would get out of the way” because its actions were preventing bond prices from falling.
That leaves us in a strange state: business fundamentals have collapsed in many sectors, but equity and fixed-income prices are still high – the exact opposite of what PE firms want.
Point 2: Is Private Equity a “Long-Term” Asset Class?
My answer here is: “Kind of, but less so than you might think.”
Yes, some private equity funds last for ~10 years, but fundraising cycles have been accelerating.
Once a firm raises a new fund, it waits an average of just over 3 years to raise the next one.
That means they’re using short-term performance data from the first few years to market the next “long-term” fund.
Many PE firms already play games with their performance data by including both realized and unrealized gains, and we’ll see even more of that as they try to “exclude” coronavirus-related losses.
That will make it more difficult to raise funds because LPs will become more skeptical of the performance figures.
And if firms want to list their legitimate results, it will slow down fundraising cycles because they’ll have to wait for a recovery before raising their next fund.
Point 3: What About Capital Calls?
In theory, PE firms can ask their LPs for additional capital when needed.
But if the LPs are not in a position to provide that capital – usually because they’d have to sell other holdings to raise the cash – then all bets are off.
LP defaults were already happening when the crisis first began, so they’re probably up to an even higher level now.
And even if a capital call works and helps portfolio companies survive, it still reduces returns, further hurting performance data.
Broken Business Models and Politics
Finally, a few other factors have emerged that make me skeptical of the industry’s prospects.
The first is that the business model of traditional leveraged buyouts doesn’t work in a pandemic.
Adding leverage and making companies “more efficient,” usually by cutting costs, work as long as sales continue to roll in.
This model also works when interest rates are low because additional leverage isn’t that expensive.
But what happens if a company’s revenue suddenly drops by 50% or 80%?
At that level, low interest rates and “added efficiencies” are irrelevant because the company can’t even cover its baseline operating expenses.
PE and VC-backed companies cannot claim government money from the CARES Act (and likely any future stimulus), so firms don’t have many options for troubled portfolio companies. The main ones are:
- Hope a capital call works or attempt to raise additional funding in the public markets (accept dilution and lower returns).
- Restructure or declare bankruptcy (potentially get wiped out if creditors seize control).
- Hope for a quick recovery and enough cash to last until then (well, the deus ex machina works in movies, right?).
Even if there is a “quick recovery,” such as one that takes 1-2 years rather than 10, there’s another problem: significant political pressure will build against the industry.
The government’s response to the pandemic is only widening income and wealth inequality, so you can expect protests and demands for new regulations, wealth taxes, financial transaction taxes, restrictions on leverage, and more.
Politicians will point to companies like J Crew, Neiman Marcus, and Toys R Us, say that private equity firms crushed them and destroyed jobs, and use it as justification to change the industry.
In other words, Elizabeth Warren’s proposals could easily become a reality.
What About Other Sectors?
I’m not going to write a full breakdown here, but in short:
Investment banking will hold up a bit better because companies always need liquidity and funding. Yes, very few M&A and equity deals are taking place right now, but debt offerings and restructuring deals are off the charts.
The same applies to areas like corporate banking: whenever companies panic and need liquidity, CB benefits.
Hedge funds will be a mixed bag. Yes, the crisis has created some opportunities, but central-bank intervention has also hurt their ability to find bargains.
Venture capital will also be mixed; some tech and biotech portfolio companies may benefit from the crisis, but many of them are not true tech companies.
For example, Uber is more of a “bad transportation company” than a tech company, as it loses absurd amounts of money and has low gross margins.
Companies like that will suffer, so the results will vary tremendously by the fund.
Neither one will do so well at airlines, retail, restaurant, or travel-related companies, but they’ll hold up in less-affected sectors.
In corporate development, one positive is that professionals don’t necessarily “need” M&A deals to stay employed; they could work on joint ventures or partnerships, or they could survey the industry landscape and do research.
Commercial real estate will also suffer, but mostly in the office, retail, and hotel markets; demand for industrial space (warehouses) and data centers will rise, and multifamily demand won’t change much.
The Bottom Line: Is Private Equity the Biggest Loser?
Looking at everything above, I’ll revise my initial thoughts a bit.
I don’t necessarily think that private equity will be the “biggest loser” in the finance industry as a result of this crisis, but it will be among the sectors that decline in the long term.
The biggest issue is that business fundamentals have collapsed, but asset prices have not fallen nearly as much due to massive intervention from central banks.
Also, the traditional LBO business model doesn’t work in times of severe crisis (as some former PE insiders have noted).
That said, growth equity firms and smaller PE firms that do not rely on leverage and cost-cutting may hold up better.
I don’t think you should necessarily “avoid” private equity because of these points.
The large firms will probably continue to recruit on schedule, as usual.
But in the long term, the industry will become less attractive, the pace of fundraising may slow, and there will be fewer openings.
And once the politicians pile on, things could get even worse.
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