How’s the PE Winter looking?

It’s amazing to think quite how recently private capital management was a pretty-much-nothing industry. Back in 2003, the entire sector’s AUM was less than $500bn. That’s around a quarter of an Nvidia or a single SPDR S&P 500 ETF.

Things have changed.

Along the way, Blackstone overtook BlackRock to become the most valuable asset management firm and the private market explosion brought riches to many many managers, as well as prompting a growing political backlash.

But, as readers know, not all is hunky-dory in PE-land. Exit values are down 66 per cent from their 2021 peak. In 2023, 38 per cent fewer buyout funds closed, and deal values have fallen by 60 per cent over the past two years.

With public markets surging and the US steadfastly refusing to enter recession, what’s been going on? The short answer is that higher bond yields have clogged up the PE pipeline. Bain & Co’s latest private equity review gives a longer answer. This was expertly covered in MainFT upon release, but we thought we’d take the chart-curious through an extended parsing of the report.

The PE Pipeline

Much of private equity works on a five-step process:

1. Collect client capital commitments

2. Buy firms

3. Strip assets and gear up Improve firms

4. Sell firms and return capital to clients

5. Profit!

For the industry to work, the pipeline has got to keep moving. Assets are often acquired with term loans that must be repaid or refinanced around five to seven years later. This helps to set the tempo. So let’s check in on each of these steps to see where the congestion lies.

Step One: Raise capital

Values are down but by no means out. Around $1.2tn of fresh global private capital was raised in 2023, according to Preqin. Sure, this is less than the $1.5tn in 2022 or the $1.7tn of 2021. But still, 1.2 TRILLION DOLLARS! Bain is down about this, saying:

. . . as of January 2024, approximately 14,500 funds across the industry were on the road seeking $3.2 trillion in capital and only $1 closed for every $2.40 targeted, marking the worst supply/demand imbalance in more than a decade.

But STILL, $1.2 TRILLION!

A lot of the capital raised will have progressed through to Step Two, but not all. When a client (the Limited Partner, or LP) signs up to invest $100mn in private equity, they don’t immediately assume $100mn of exposure. Instead, they make a commitment to provide $100mn to the manager (the General Partner, or GP) as and when the GP wants it. It can take years before all the money is invested. This uncalled capital is called ‘dry powder’.

How much dry powder is there? Bain reckons $1.2tn in buyout, out of maybe $3.9tn across PE more generally. Around a quarter has sat there, uninvested, for more than four years.

Why isn’t this dry powder just invested? It can take time to find the right deals, although as time ticks on the pressure to do a deal — any deal — rises.

Step Two: Buy firms

While only one subset of PE, global buyouts are a big category, and one we’re going to home in on. Buyout deals totalled $438bn last year, down 37 per cent on the year and the lowest since 2016.

Deals reliant on bank finance basically collapsed. It’s not that the funding wasn’t available. It’s more that leveraged buyouts don’t work so well when the cost of debt doubles.

From 2020 to 2022, debt-to-EBITDA multiples on new LBO loans averaged between 6.9x and 7.1x. In 2023, this collapsed to 5.9x, presumably because you can’t realistically leverage a firm seven times if you’re paying 11 per cent interest a year. As you might imagine, this causes problems in keeping the pipeline chugging along (more on this later).

Step Three: Improve firms

The report is light on metrics to show how firms have been improved over the course of their lives in private equity hands. This is a shame, because there is no shortage of compelling accounts making the case that the industry is pretty vampiric, and we always enjoy a bit of fightback.

You could argue that any improvement to a portfolio company will be captured in any increase in the multiple of EBITDA that it is sold for versus that for which it is bought. But for Bain multiples are:

essentially a math issue: When rates go down, multiples of cash flow go up, and vice versa

How about operating margin improvement? According to Bain “margin improvement has contributed practically nothing” to value-creation. Instead, they reckon uplifts in portfolio firm valuations have historically been due to revenue growth (at a sub-nominal-GDP pace?) and multiple expansion. And they have a chart to prove it:

This doesn’t look, prima facie, like an argument that private equity improves firms, but let’s park this for now. Because we’re coming to the big one: exits.

Step Four: Sell firms and return capital to clients

As Bain puts it “it’s safe to say it has rarely been harder to sell a portfolio company” in “the most challenging environment for closing deals in a generation”. Exit channels are “in deep freeze”, and there are 28,000 unsold companies marked at $3.2tn piling up in buyout portfolios, 46 per cent of which are four years old or older. The backlog is four times larger by value than it was during the global financial crisis. Not all these unsold companies will be duds. Only 30 per cent are marked at a value less than invested capital, although we’ll have to wait until they’re sold to see how firm that figure is.

Exit multiples on PE deals that have closed have held up pretty well. But this, Bain reckons, is because funds have only been able to sell their best firms, which command the highest multiples.

Last year, buyout funds returned $345bn, the lowest in a decade. Is this another ‘death of the IPO market’ thing? No. Most private equity exits don’t involve floating the company on a stock exchange. Last year, 80 per cent of exits were sales to corporate buyers ($271bn). The next most popular exit was sales to other PE firms ($62bn). In last place is IPOs ($11.8bn), having risen from $6.9bn in 2022. As Bain shows, IPO exit has been a niche exit route for maybe twenty years.

Some of these trapped investors will roll into continuation funds, but a lot of clients are wary of them. But we know what you’re thinking:

You are seeing a snapshot of an interactive graphic. This is most likely due to being offline or JavaScript being disabled in your browser.

This has always been a thing. And it’s not insignificant. But sponsor-to-sponsor deals have contracted at a faster pace than sales of portfolio companies to strategic corporate buyers.

Remember that five-to-seven-year term debt that keeps the tempo? It looks from this chart that about $300bn of it is due for repayment or refinancing by the end of 2025:

We can’t think of a time when the bond maturity wall has proved too large to refinance, but the impact of refinancing at higher rates? That can hurt. And interest cover looks from this chart to have been deteriorating pretty rapidly:

It’s almost as though the private equity boom was based on cheap leverage rather than the skill of private equity managers.

Anyway, this collapse in exits is a big deal. What does Bain reckon it will take to get the pipeline moving again?

“Getting exit markets unstuck will likely take two things: meaningful easing by the Fed in the year ahead and efforts to justify those high multiples [paid on 2020-21 vintage deals] through the hard work of creating new value at portfolio companies.”

With a shift from the six cuts priced in at the start of the year to a 20 per cent chance of the next move being a hike, all we can say is “Yikes”.

What next?

It’s worth quoting Bain at length about what you need to believe for this not to be a problem (our emphasis):

. . . with a large volume of portfolio companies facing refinancing hurdles, it will be critical that debt holders take the stance they did in 2008–09. Lenders clearly didn’t want the keys to a bunch of troubled portfolio companies then and probably don’t want them now. That leaves open the opportunity to pay a penalty, add some equity, and arrive at a workable capital structure.

2008-09? Sheesh. ‘Pretend and extend’ was a strategy widely employed by banks following the GFC. When firms couldn’t pay back debt, it was simply rolled over. But this was only possible because rates had collapsed. It might be harder to pull off this trick in a much higher rate environment. Could a tsunami of private equity debt restructurings be on the horizon as public equities approach fresh highs?

Who Cares?

Does it really matter if cogs in the billionaire factory are a bit jammed? I mean, sure, private equity dudes care, but should the rest of us? After spending the last decade watching these guys buy mansions, fly around in private jets, launch expensive legal defences, and buy superyachts, is it time for a bit of schadenfreude?

Maybe not.

First, there are the workers. In a speech on Monday, the Bank of England’s Nat Benjamin reminded us that 2.2mn people in the UK work directly for private equity portfolio companies.

That’s one in every seventeen people with a job — 10 per cent of people working in wholesale and retail, and 17 per cent of people in the information and communication industry are directly employed by a PE portfolio company. And utilities might be a bit *ahem* exposed. Check out this cool Marimekko chart that Louis made showing the number of people employed and the share of the total industry employed by PE:

You are seeing a snapshot of an interactive graphic. This is most likely due to being offline or JavaScript being disabled in your browser.

The proportion of working Americans employed by private equity portfolio firms is even higher. That such a large share of the workforce might be working for “a bunch of troubled portfolio companies” is . . . sobering?

Then there are the banks.

In another Bank of England speech this week, Rebecca Jackson — the Bank’s executive director for Authorisations, Regulatory Technology & International Supervision — outlined how banks aren’t really set up for dealing with decisions made at the PE company level. Leverage has been applied ‘downstream’ at the portfolio company level, ‘upstream’ with recourse to GPs and LPs, and ‘midstream’ to the funds that own portfolio companies in the form of NAV loans. 

Many banks, she reckons “are unable to uniquely identify and systematically aggregate or measure their combined credit and counterparty risk exposures to the private equity sector”. 

This might not matter. After all, you would hope the banks did their due diligence at the individual portfolio company level. But one lesson from the bank run that led to SVB’s collapse was that what appears to be a diversified client base can quickly be understood as a lot of dudes taking their cues from a few head honchos.

Like all truly successful capitalists, PE managers appear to have assembled human shields around their ability to extract seven figure payouts. 

So yes, sigh, we do all need to care about them.

Further reading
— Norway says ‘nei’ to private equity