Private Equity's Secret Bubble
In this inaugural post, I will discuss the bubble that has quietly formed in the private equity market and why I believe it will pop in the next 12-24 months.
A decade of free debt has created bubbles in nearly every asset class around the world. The S&P 500, for example, had gained nearly 340% from its 2009 lows to the 2018 high. Even after the correction in late 2018, the S&P is still up about 280% from the 2009 low. Keep in mind that this correction was prompted by a 25 basis-point hike in the Federal Funds rate in December. This brings me to my point: there is a bubble in the private equity market and 2019 may be the year that it pops.
Private equity investments are inherently less liquid than publicly traded equities. As a result, GPs provide their LPs with very specific timelines and expected returns in order to encourage investment in their funds. The timeline is generally around 5 years from investment to exit, and the "target IRR" is generally between 20%-30%. These returns can be achieved on these timelines for a few reasons: The first is that private equity firms are known for adding value to their portfolio companies. They come in with a "playbook" to grow the company at the clip necessary to provide the target IRR without relying on selling at a higher EBITDA multiple than they paid. The second is slightly less obvious, but still simple. Leverage: the more debt used in the deal, the higher the IRR, ceteris paribus. So, making the target return during the promised timeline shouldn't be a problem, right?
Unfortunately, its not quite that simple. Multiple contraction creates big problems for PE funds and, as the below figure shows, multiples peaked in 2014.
Why is the 2014 peak so important? Well, PE funds who paid 12.4x for their portfolio companies in 2014 will be looking for exits in 2019, as their LPs were promised liquidity 5 years after the initial investment. While it is no secret that IPOs have become a less common exit for PE funds, the last few years have seen some very successful exits via corporate acquisitions (Adobe's 2018 acquisition of Marketo comes to mind, a great exit for Vista Equity Partners). But with interest rates and volatility on the rise, who is going to pay 12.4x to provide the promised return in 2019? Well, as it turns out, PE funds are already resorting to secondary buyouts (SBOs) for their exits. The figure below shows that SBOs accounted for the majority of PE exits for the first time in 2018.
Why is this a problem? In many cases, an SBO merely creates the illusion of an exit by shifting the portfolio company from one fund to another, often within the same firm. Because these funds tend to have some of the same LPs, it is not uncommon for an LP to be invested in both the exiting fund and the acquiring fund - essentially buying the company from themselves, while the brokers, bankers and GPs all collect fees on the transaction. Imagine, if you will, buying a house from yourself: you pay the realtor and all of the taxes and fees associated with the sale, but you're left in the same house you already owned. Is this worth it for LPs? A recent study by the Harvard Business School says no. Their study found that, on average, LPs earn a 15% lower IRR on SBOs than initial buyouts.
In the past, GPs have been able to massage this problem by taking on more debt with each secondary buyout, thus at least providing their LPs with some liquidity by using less equity in the secondary. However, with interest rates rising, I suspect that many GPs will find themselves stuck: over-leveraged and out of time, PE funds will be stuck holding the bag(s). They will have to sell these portfolio companies at a significantly lower multiple than the 12.4x they paid 5 years ago. Needless to say, their LPs will not get the return they expected and as a result, will be less likely to invest their capital into private equity (buyout) funds in the future.
These trends paint a concerning picture for the future of private equity - and I expect this to become clear later this year, when Uber's PE and VC investors (who have already poured $24.2 billion into the company) try to dump their bags on the public in what may be the most overpriced IPO of all time.