The 2008 market collapse was led by the housing bubble.
The 2000 market collapse was led by the technology industry.
Each of these market collapses was sparked by the flames of excessive leverage and unrealistic growth projections. Will the excessive leverage and unrealistic growth expectations of Private Equity lead to the next market collapse?
What is Private Equity?
Private Equity (PE) is a type of investment that involves buying and managing companies that are not publicly traded on stock exchanges. For the most part PE is dominated by leveraged buyout funds. These funds purchase a company by leveraging up the debt in the company to approximately 75%. Then, they hope to service the new debt by cutting costs and hopefully growing the company revenues. According to McKinsey, the Private Equity market’s assets under management totaled $13.1 trillion in June of 2023. According to Ernst and Young as of May 2021, Private Equity directly employees over 11 million people. The major market players include Carlyle, Blackstone, KKR, and Apollo.
Early Success
Initially, PE firms were the darlings of Wall Street. Falling interest rates and lack of market competition allowed firms to cherry pick low-tech, non-cyclical, profitable firms using mostly non-recourse debt. These firms were able to produce outsized market returns mostly on the heels of excessive leverage. As these returns were published, they gained the attention of Pension Funds, Endowments, and the large Private Wealth groups of the major investment firms. As is the flaw of most investors, they started chasing most recent performance and allocated as much as 30% of their assets to private equity and hedge funds. This was a windfall for PE firms.
The Price of Success
Firms like KKR, Apollo, and Blackstone began to tout their lavish lifestyles and exuberant incomes. Steve Schwarzman, of Blackstone, swaggered around Wall Street while financial news outlets boasted of his $1 billion a year income. This enticed a large number of money managers to enter the PE industry. Today, according to Jeffrey Hooke, there are more than 4,500 PE firms. This increased competition for new deals, which ultimately reduced margins and increased risk. This also attracted some of the greediest elements of Wall Street. Warren Buffett and Charlie Munger commented in one of their annual meetings that PE has misled investors on how their returns are calculated and has lied to investors to make the money come in.
Declining Performance
For the last twelve years, PE funds’ performance has underperformed relative to the S&P 500, according to research done by Jeffrey Hooke. This has reduced the appetite for investing in these funds and has caused many investors to request redemptions. This creates a situation where the fund managers will either need to borrow money to fund redemptions or sell the companies.
Declining Valuations
The problem with trying to sell these companies is that rising interest rates have caused these companies to fall in value from as much as 30 to 40 percent. This has forced PE funds to try and borrow funds in order to meet redemption requests. If they are unable to borrow the funds, investors will be forced to stay in a losing fund hoping markets will improve. Starwood Capital recently told investors they were going to gate any requests for redemptions. This essentially means that investors will not be able to get their money back. Only recently has Blackstone begun to honor their redemption requests, according to Bloomberg.
Rising Interest Rates
The rising interest rates have not only reduced valuations but have also increased risks associated with PE investing. For example, now that valuations have fallen, banks have created capital calls on companies to maintain their loans. Now funds need to borrow money to satisfy redemptions and companies in the funds need to borrow money to remain solvent.
Creative Financing Vehicles
This has created two new types of financing. The first is called NAV financing. This is where the fund goes to the banks and asks to borrow money based on the value of the fund. The fund then uses the borrowed money to fund redemptions and to loan to companies in the fund to satisfy capital calls. When this credit line is exhausted the next line of financing is called Manco financing. This is where the management company (KKR, Blackstone, Apollo) goes to the bank and tries to borrow money based on the fees they extract for managing the fund. This borrowed money is then lent to the fund and to the companies in the fund. The rates of interest on these two types of financing can be extremely high. Reports from Lionpoint suggest these loans could be as high as 20 to 30 percent. This is why you see many of the major firms pushing a new asset class called Private Credit. They hope to save some of their biggest clients and sacrifice the smaller ones.
Can They Last?
Dr. Edwin Burton of the University of Virginia once asked a group “What makes a company go out of business?”. The normal flailing of answers followed: not enough earnings, increased competition, government regulation, etc. “No, the real reason a company goes out of business is the inability to borrow money. Just look at our government.”
As long as PE can find a way to borrow money, they will stay in business. They can gate their clients so they will not need to pay investors and they can use borrowed money to pay back borrowed money. This is not a bad gig for the fund managers considering they will still be collecting fees.
If the Clock Strikes Twelve
For years, PE investors and fund managers have been like partiers at the Cinderella Ball without any clocks on the wall. Lavish fees and luxurious lifestyles have blinded any concerns of historically low interest rates not continuing. The clock on the wall is now a time bomb and it is ticking. If rates do not decline and valuations do not return to sustainable levels, bankruptcies will skyrocket, banks will fail, unemployment will rise, and asset prices will drop abruptly. Pension funds and Endowment funds who boast of the efficacy of asset allocation and efficient markets could see their values drop to 2008 levels. This will leave smart and liquid investors the opportunity to pick up cheap assets.
Measuring The Risk of a Market Collapse
There are two different measurements which can be used to control the amount of risk during market downturns. These are maximum downside return and length of time for recovery. These two measurements explain how far your portfolio would fall in value and how long it would take for you to get back to even if you were invested in a portfolio which matched the S&P 500.
For example, during the 2008 Great Financial Crisis (GFC), the market, as represented by the S&P 500, saw a total downturn of -47.74%. The time it took for the market to recover was 5 years and 6 months.
Investment Styles to Prepare
While the asset allocation models used by most investment firms try to time moving in and out of different asset classes, there are investment styles that allow the investor to invest through market collapses.
Historically successful investors like Benjamin Graham, Warren Buffett, Charlie Munger, and Seth Klarman have avoided asset allocation models and have chosen to invest in individual stocks according to specific valuations that have proven to have predictive results. The following are two examples of this method.
- Largest Food stocks with the highest dividend yields
During the 2008 GFC, this strategy had a maximum downside of -18.89% and the recovery time was 1 year and 6 months. The average return for this strategy from 1969-2022 was 18.05%.
- Largest Drug stocks with the lowest price to book
During the 2008 GFC, this strategy had a maximum downside of -14.50% and the recovery time was 2 years and 6 months. The average return for this strategy from 1969-2022 was 14.62%.
Both of these strategies’ downside was less than half of the market, and the recovery time was cut by more than half. Please know these are not recommendations. These strategies may not be suitable for all investors. These strategies are compiled from Compustat, CRSP, SEC, and Yahoo Finance and do not reflect the returns of any of my clients.
Conclusion
Private Equity has been the darling of the asset allocation models that have dominated the investment strategies for Pension Funds, Endowments, and Private Wealth Management firms for the last 30 years. This once great strategy of finding private companies that were mispriced and developing them into more effective companies, has become a crowded and extremely risky investment, relying heavily on low interest rates. When the clock strikes midnight, there will be a pair of glass slippers. To find the owner of the glass slippers, the investor must prepare for the collapse by investing in individual stocks according to valuations, which have proven to have low downside risk and reasonable recovery times.