Bilal’s Macroscope: Private Equity Bubble to Burst

Remember those Road Runner cartoons where Wile E. Coyote would run over a cliff and be suspended in the air for a while before he fell down? Well, that’s how private equity (PE) performance feels right now – suspended in mid-air before a big drop. The value of companies held by PE only fell marginally in 2022. That was despite a 20% drop in US publicly-traded stocks. The fact that PE firms themselves perform the valuations likely explains the divergence, but the fundamentals look poor for 2023 and so it is only a matter of time before valuations come back to earth.

Private Flows Slowing

The surge of capital entering private markets has undoubtedly helped support PE valuations. In the aftermath of the global financial crisis, $290bn entered private markets but by 2017 onwards that had reached $1 trillion with 2021 being the largest on record with $1.2 trillion raised. The largest proportion of this was PE (followed by venture capital and real estate). 2022 has already seen funds raised declining by perhaps 20%, which suggests the inflows are finally slowing.

Profitable Opportunities Disappearing

But the larger worry is of declining returns. PE funds’ median self-reported internal rates of return (IRR) fell to a paltry 3.6% for 2021 vintage funds. It is 11% for 2020 vintage funds and 24% for 2019 vintage funds. On top of that, the paid-in capital for PE funds has been falling sharply. Even 2019 vintage funds only have 74% paid-in capital, which means that over a quarter of the funds raised for those funds have yet to be deployed. This means PE funds are struggling to find attractive targets. 2021 vintage fund meanwhile have over 75% of capital sitting on the sidelines.

What is most worrying is that private equity funds are unable to exit their investments in public markets. In 2020 and 2021 almost one-third of PE exits were in public markets, while in 2022 it fell to almost zero. Instead, PE firms were exiting to other PE firms or to strategic partners. The fact that the most efficient market (the public one) is not willing to accept PE valuations is a tell-tale sign of PE firms holding overvalued assets.

Higher Rates Undermine PE

PE firms are struggling to get lending from banks. Leveraged finance markets are almost shut, so PE firms are turning to private markets for credit. With interest rates on leveraged loans at over 10% it is no surprise PE firms are struggling to make the numbers work for leveraged buy-outs. For most of the post-GFC period, those rates were almost half.

Stepping back, it is clear that the post-GFC period of low rates provided the foundation for the PE boom. Investors piled into PE funds, who in turn were able to borrow at low rates to acquire companies in sectors like tech which themselves benefited from low rates. The collapse in rates after COVID saw a final surge in these dynamics, but now that the Fed and other central banks have ramped up rates, the PE bubble is finally starting to burst. For now, PE firms are able to maintain over-valuations on their assets by selling to one another, but as the year goes on, valuations will have to marked down.

While it is unclear whether PE crashing could lead to systemic issues, it could lead to a political fall-out. It appears that amongst the largest investors in PE have been pension funds. A significant mark-down in their PE holdings could see calls for a public bail-out much like what was seen in UK pension funds after the LDI debacle of 2022. It could also bring new regulatory action against pension funds for taking on such high cost, poor performing investments (they have barely outperformed public markets since 2008).

Our Current Discretionary Trades

We are changing (some) things up to start 2023 by closing our short German 10-year trade (closed +0.9%) and by adding to our China trades. Currently, our trades are:

• EM FX crosses: long THB/TWD (target: 92)
• China reopening: short USD/CNH (target: 6.75),short USD/CLP (target: 820), long HSI (target: 21,000)
• EM rates rally: receive 1s5s MYR IRS

What Are Models Signalling?

Markets are yet to return to full steam. Models, on the other hand, need no warmup. To start 2023:

• Momentum models are signalling for a continued road lower in the S&P 500 and GBP/USD. They also flipped bearish on AUD/USD.  
• FX carry models are yet to budge from short JPY or CHF while they performed well over the Christmas holiday.

Recent Questions From Clients

• Are there any non-consensus views?
• Will the BoJ adjust YCC again?
• When will Euro money market curve invert?
• Can the US avert a recession in 2023?
• Why aren’t commodities stronger on China’s re-opening?

What I Am Reading

• ‘Disruptive’ science has declined — and no one knows why Looks like science is becoming more incremental than revolutionary
• The Social Recession: By the Numbers Fewer friends, relationships on the decline, delayed adulthood, trust at an all-time low, and many diseases of despair.
• More ways to use ChatGPT here
• Newly Launched Solar Sail Is on Track to Unfurl in Low Earth Orbit A solar sail!
• Not Drinking Enough Water Linked to Serious Health Risks, Study Warns
• Nicolas Cage as Dracula! Yes, the trailer for Renfield has arrived. Looks quite mad
• The Best Movie Posters of 2022 These are cool

Bilal Hafeez is the CEO and Editor of Macro Hive. He spent over twenty years doing research at big banks – JPMorgan, Deutsche Bank, and Nomura, where he had various “Global Head” roles and did FX, rates and cross-markets research.

(The commentary contained in the above article does not constitute an offer or a solicitation, or a recommendation to implement or liquidate an investment or to carry out any other transaction. It should not be used as a basis for any investment decision or other decision. Any investment decision should be based on appropriate professional advice specific to your needs.)