Private Equity Bubble to Burst

Summary

• Private equity companies are performing suspiciously well and appear overvalued.
• Private flows are slowing: 2022 has already seen funds raised declining by perhaps 20%. And internal rates of return (IRR) are down significantly.
• Higher interest rates are also undermining private equity, with PE firms struggling to get lending from banks.

Market Implications

• While it is unclear whether PE crashing could lead to systemic issues, it could lead to a political fallout – especially as pension funds appear to have been among the largest investors in PE.

Remember Road Runner?

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? Well, that is how private equity (PE) performance feels right now – suspended in mid-air before a big drop (Chart 1).

The value of companies held by PE only fell marginally in 2022. That was despite a 20% drop in US publicly traded stocks (Chart 2). That PE firms themselves perform the valuations likely explains the divergence, but the fundamentals look poor for 2023, 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 (Chart 3). 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 (Chart 4). 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 (Chart 5). In 2020 and 2021 almost a third of PE exits were in public markets, while in 2022 it fell to almost zero (Chart 6). 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 buyouts (Chart 7). For most of the post-GFC period, those rates were almost half.

Stepping back, the post-GFC period of low rates clearly provided the foundation for the PE boom. Investors piled into PE funds, who in turn could 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 the Fed and other central banks have ramped up rates, the PE bubble is finally starting to burst. For now, PE firms can maintain over-valuations on their assets by selling to one another. But as the year goes on, valuations must be marked down.

While it is unclear whether PE crashing could lead to systemic issues, it could lead to a political fallout. Pension funds appear to have been among the largest investors in PE. A significant markdown in their PE holdings could see calls for a public bailout, 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).