“An extraordinary 40-year history of private equity is over” as era of cheap debt gives way to higher interest rates, City figures announced .
Guy Hands, founder of private equity firm (PE) Terra Firma, says the industry is at risk of facing a reckoning similar to the securitization market, which he called “crack cocaine.” financial markets ahead of the global financial crisis.
Meanwhile, Grand City Archie Norman, non-executive director of Bridgepoint and chairman of Marks & Spencer says higher interest rates mean bosses will have to put up with lower incomes because debt is “an important part of their [PE firms'] success.”
The Bank of England raised interest rates on the 13th last month. to 5% in a row, the highest level since 2008.
Threadneedle Street is raising the bank rate to curb the soaring inflation that threatens to take root in the economy as domestic spending such as services rises.
Private equity funds, architects of leveraged buyouts, are among those most exposed to rising interest rates as the cost of servicing debt in portfolio companies is now much more expensive.
Now the sector will have to “find alternative sources” . Capital” if he wants to survive, according to Stephen Quinn of 17Capital. “Rising interest rates are definitely a problem,” he adds.
2306 b.o.e.
Critics' prophecies that the world's foreclosure moguls face retaliation have abounded ever since PE broke into the financial markets in the 1980s.
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Vincent Mortier, chief executive of Amundi, Europe's largest asset management company, has previously compared PE to a “Ponzi scheme” that will collapse in the next three to five years.
But as one seasoned analyst says: the problem is that people have been talking about it for the past 40 years, and PE just kept going up.”
Terra Firma's Hands looks back to the early 1980s, when US government interest rates were nearly 16 percent.
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“While it was extremely difficult to do private equity deals in the early 1980s, these deals could be refinanced at lower interest rates with an equivalent reduction in the cost of capital,” he says.
“[This] meant that even without efficiency gains or revenue growth, the deals were profitable.
“Now we are facing the opposite situation, and the recent increase in interest rates and the resulting increase in the cost of capital means that in order for a private equity deal to work, you need either a significant increase in efficiency or a huge increase in revenue.
“In short, PE, due to a favorable environment for much of the last 40 years, is now facing the exact opposite. It will be extremely difficult to deal with.”
Norman is less pessimistic, arguing that debt remains an important part of PE's success.
“When interest rates go up, PE returns may go down, but of course public market returns go down as well,” he says.
“Having said that, if you talk to any of the big charities, asset allocators, they will tell you that in order to make a competitive return on your portfolio over the last 10 years or the next 10 years, they need a significant PE Allocation.
“PE has performed better on average and will likely continue to do so.”
Norman says PE has been suffering from higher interest rates for some time now – in many cases before the hike base rate.
“Over the past three years, many portfolio companies have been taking loans not from banks, but from credit funds, already at rates of 5 to 7 percent. So raising interest rates is probably having less of an impact than one might think,” he says.
However, Hands believes there are “a huge number of problems” coming, which will be concentrated between individual firms, rather than being distributed evenly across the industry.
Guy Hands of Terra Firma says the private equity industry is facing “enormous challenges.” 39; Photo: JULIAN SIMMONDS
He adds: “The change in the interest rate has happened much faster than anyone expected.”
“There will be relentless pressure on all aspects of society, and some businesses will collapse.”
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The pressure on PE has been mounting over the past 18 months, even before central banks decided to raise interest rates to fight rising inflation.
Corporate auctions for companies including large pharmacy chain Boots and Motor Fuel Group, the UK's largest filling station operator, failed to attract the multi-billion dollar bids that their owners expected in the spring of 2022.
And just last week It has emerged that Canadian investor Brookfield has been struggling to generate interest in Center Parcs, which it recently put up for sale for around £4bn.
17Capital's Quinn says “the mismatch in buyer and seller expectations” after the economy pulled out of the Covid pandemic is exacerbating the situation. He suggests that PE managers are almost unwilling to admit that their assets are not worth what they think.
Quinn adds: “If debt is worth more and availability is less, then logically the funds cannot pay that same price as when interest rates were near zero and debt was more affordable.”
“This is part of the reason why the number of exits has dropped substantially over the last 12-18 months. The number of new PE deals also dropped significantly. This is why alternative sources of liquidity, such as NAV funding or the secondary market, have come into play.
Secondary transactions, where one personal investment company sells a portfolio company to another, are also referred to as “package transfer” assets.
Historically, about one in five assets is transferred from one buyout firm to another.
The logic is that a small private equity firm moves the business forward until it is handed over to a larger fund that can accelerate further growth.
Norman says: “All private equity portfolios should be closed, usually within 10 years, and in order to be successful, most of them within six years. When the IPO market is effectively closed – and when there aren't many buyers around – you need to find an alternative exit.”
Quinn says the number of secondary deals has now risen to about one. at four. And the growing reliance on parcel transfer deals could be the canary in the coal mine for PE.
Whether parts of PE's “ponzi scheme” collapse, as Mortier put it, most likely depends on whether the their own industry investors, their limited partners.
One analyst who began his career during the buyout boom of the 1980s says: “As long as investors continue to believe that PE has access to some special magic that investors are willing to pay extra for in fees, the juggernaut will not stop.
“Investors have been hit by cyclical downturns before, but PE continues to rise. One reason is that many investors don't really understand where their income comes from.”
Archie Norman of M&S believes that the private equity industry will be able to successfully overcome the high interest rate regime. Photo: Adrian Brooks/Imagewise
Norman says: “Leverage is still an important part of many private equity investments. PE people often speak as if they have a different management or leadership model. It's different, but not that different.”
Studies have shown that if the S&P 500 of the largest US companies had the same amount of debt invested as in PE, the return would be comparable.< /p>
However, Hands fears the worst, comparing PE to the securitization boom before the credit crunch, when loans and other investments were pooled and sold to investors on the assumption that they were buying less risky assets.
faced by securitization in 2008. Securitization has become crack cocaine in the financial markets,” he says.
“It is possible that most PE deals will survive. A big jump in interest rates in the 2020s is a good thing.”
But the founder of Terra Firma, one of Europe’s best-known private equity funds, fears many firms could fail.
>“Will PE disappear? Of course not. But will it become a less safe and less attractive place to invest and work? Absolutely,” says Hands.
“Since 1980, this has been the best place to invest and make money in the whole world. This incredible 40-year history has come to an end, and financially motivated students of international business schools should start looking for a new career.
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