Private equity’s public reckoning

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Private equity is a bit bunged up.

The fairy tale, if you like, with these buyout firms is that they buy unloved, lowly companies, fix them up into shiny, amazing companies with their special brand of management genius, and then list them on public stock markets.

Ka-ching!

Money rains from the sky, everyone is happy.

Now like I say that's the heroic origin story.

Terms and conditions apply.

But anyway, the last bit of that process has issues.

Launching companies onto public markets is proving much trickier than people had hoped.

Instead, private equity firms are passing companies around to each other or even selling them to themselves.

Listeners, you're not alone in thinking this makes very little sense.

So today on the show, we're asking, why is private equity constipated?

And will this all blow up in everyone else's faces?

This is Unhedged, the markets and finance podcast from the Financial Times and Pushkin.

I'm Katie Martin, a markets economist at the FT in a rather autumnal London.

And I'm joined down the line from New York City by my comrade Rob Armstrong from the Unhedged newsletter.

I wish it was autumnal here.

It still feels like summer right now in New York.

Always complaining.

But also, by our private equity man in New York, Antoine Garra.

Antoine, welcome.

We're delighted to have you here.

Hi, thanks for having me.

So, look, normal people don't know what private equity is, and they certainly don't know what a continuation fund is.

So, Antoine, please enlighten the class and also give us a sense of how big and important is this stuff.

Sure.

Private equity is a fairly simple business when you think about it.

Firms raise money from pensions, our professional retirement funds, sovereign wealth funds, and you say, I'm going to go buy 10 to 15 companies in a fund.

I'll spend the first four years buying the companies, and the fund will be 10 to 12 years.

And by year five, you'll start to really see the money come pouring back in as we buy companies, fix them up, apply a little bit of debt to them, and make good money, two to three times your return is the general expectation.

And so that's a fairly simple business because it's bound by time the cash goes out to the private equity fund and then it comes back and if everyone's happy they'll do it all over again.

Okay, I just want to stop and ask a question here.

I have my answers to this question and you have yours.

So if over 10 years you're kind of 2xing or 3xing your money

If I'm getting this right, that's like 20% a year plus,

right?

That's a meaty return.

Right.

Even a remarkable return.

Just give us in a short answer.

What's the magic that allows these guys to do 20% or more a year?

Okay, there's a few things.

First, there's just the use of leverage.

So you're going to buy a company and use, say, half-debt financing.

So that means if you can even grow the value of the company slightly over time and find a willing buyer at the end of it, the leverage will earn you some return.

Double your return if you're using 50% leverage.

And then you're also trying to grow the business.

You're trying to repay the leverage by finding cost cuts that then

take the debt down.

And so then you've created equity value.

And you can also do all kinds of things like M ⁇ A.

And also, you're obviously trying to pick sectors or industries or companies where you feel the market has misunderstood the growth, or it's a public company that's just gotten way too beaten down.

And it's trading for less than the sum of its assets.

Aaron Powell, Jr.:

That's a nice story, Antoine.

I think you have a future in public.

Okay, wait, wait,

but there's some fine print here.

So I'll add a little asterisk.

Those two to three times returns come with a little bit of gaming because there are things called subscription line facilities where I will go do the deal, but I won't actually draw the money from my investors until

around like when the deal closes or six to the next year.

When you bought the capital.

Yeah, yeah.

And so there I'm gaining equity exposure with leverage, but I've not actually drawn the capital.

And so then if someone comes and buys the company a year or two later, I'm making very, very high returns, you know, 100% annualized return or something like that.

And so there is a little bit of gamesmanship in that 20 to 30% figure.

An easier way to look at it is like, how much cash did I put out?

How much cash came back?

And I would say a good fund to litmus is you want to double your money, cash coming out, cash coming back.

A lot of investors who have been around the industry for a while, they call it like cigar box accounting.

You're in a smoky back room, and you open the cigar box, you take the cash out, you give it to the investor, and they give it back to you and put it back in, and you make another decision 10 years later.

So, look, one thing that I think is like really important to bear in mind, Hit, is what we call exits.

So, the point at which money rains from the sky is the point at which these private equity firms, they've bought up these companies and then they manage to sell them on to other companies, or they manage to list them on public stock markets, and everyone's happy.

This is the kind of model of how private equity is.

And this is indeed, Katie, the model of all investing.

At some point, we want the money because we want to spend it, whether in our retirement

or somewhere else.

At some point, you need the money, right?

Yeah.

Or else you wouldn't have invested in the first place.

Uh-oh, here comes the money.

Let me take you.

Uh-oh.

Yeah, you know, rut-row, that's where the problem kicks in, right?

Let me tell you a little story about posh gyms in the UK.

There's a chain of posh gyms called David Lloyd.

And I'm thinking not my gym, which is above a cop price supermarket on Walthamstow High Street, but like posh gyms, you know, like nice towels and stuff.

Towels that smell like eucalyptus.

That's how you know your gym is posh.

Beautiful.

Your towels have a slightly woody and refreshing smell.

Yes, with photographs of pebbles on the wall.

That sort of gym is what I'm thinking.

Anyway, David Lloyd, photographs of pebbles.

It's owned by a private equity company called TDR, and it's just been sold by TDR to another bit of TDR in what you call a continuation vehicle.

Antoine, please help me to make this make sense.

Okay, there are two key things here.

There's the marketing pitch, and then there's the sort of skeptical read on it.

Okay, the marketing pitch is these are really nice gyms that will perform very well for a very long time.

Eucalyptus, towels, bouginess, that ain't going out of style.

So TDR is saying,

I have invested in this for a number of years.

The investment's getting old in my fund, but I...

Which is normally bad.

Which is normally bad, yeah.

But I still want to own it, and I am going to go arrange a set of new outside investors.

We'll put a valuation on it.

We'll give our investors the chance to either take the cash at the new independent valuation or they can roll into the new fund.

And so here's the glory of capitalism and financial engineering at work.

Right.

Okay.

And so the skeptical read is, okay, here.

The person who's setting the construct up is the private equity firm.

They hold all of the information.

They have the power here.

And I have to make a decision very quickly.

and they have all the information.

They're also very smart people.

Is this creating a sort of something that's generating more money in fees and so on for their pockets?

And the final point is that the rub of the story is there's another buyer, CVC, who's come into this investment, and it's through.

Private equity buyer.

Well, but it's through CVC's new, shiny, fast-growing secondaries investment arms.

So these are the

past the parcel.

These kind of past the parcels.

Well, secondary funds are to buy aging private equity deals, and you often buy them at a discount.

And it's people who are willingly going into funds who are saying, I want to keep playing private equity deals, but at a discount.

So the whole deal really gives evidence of basically

the equation has changed from the cigar box analogy I gave you earlier.

There's all these new pockets of capital, there's complexity, and there's a lot of sort of engineering and innovation that's crept into this market.

I mean, is the problem, all these secondaries and all these passing of companies back and forth between private owners, is that just a symptom of this industry getting too big?

I'm looking at a report from Bain here.

And buyout funds, the kind of private equity fund we're talking about, it's almost $5 trillion

of these things running around in the world.

I mean, how much stuff is there that you can take private and sell on to the market?

Like, am I driving by lemonade stands in my neighborhood that are private equity owned and operated by two five-year-olds at this point?

It's a symptom of a lot of factors.

One, the IPO market has been very dormant for a number of years, so it's been very hard to just take companies public.

There are fewer, as Katie, you mentioned in your column, they're just fewer active stock pickers who are eager to underwrite the the next David's gym and decide to be a long-term owner of that.

So that makes the IPO harder.

And then the other issue is basically the last five years, the wind's been blowing in the face of the industry, meaning

you are doing deals with a lot of leverage.

That leverage is floating rate debt and interest rates went up.

So you have a lot of headwinds in your face.

And then the final issue is private equity firms, about half of their asset sales are to other private equity firms, but everyone is sort of in this I need to sell phase, so that market is not actually as active as it has been in the past.

Oh, okay, wait, wait, wait.

Teacher, the thick kid in the back, has another question here.

I don't understand, given what is going on in stock markets, meaning they only go up and their valuations are incredibly rich.

And I put this question to you too, Katie, because you wrote about in your column.

How can it be hard to sell a business at a good valuation now when everything on the stock market is selling for a gajillion times equity, at least in the times earnings, at least in the United States?

How can there be a problem here?

Well, a couple of things.

Part of the problem is that over the years, private equity firms, they buy up all of these companies and they've held on to them for longer and longer and longer.

And they've sort of squeezed more and more and more of the juice out of them over that period.

So

they have less growth potential by the time the PE is done.

Apollo was talking about this the other day.

Like,

where is it?

I wrote it down.

Right.

So, in 1999, the median age of IPOs, so of companies that were coming to public markets, was five years.

Now, it's 14 years.

So, these companies are staying private for a longer time.

Private equity is kind of squeezing the juice out of them.

And by the time they come to list, they're actually not particularly appealing options to public stock investors.

So, actually, in a way, private equity companies have bricked up their own exit and now they can't get out of some of the stuff that they own.

Because what I would stress is, you know, we've been talking about David Lloyd and the posh gyms and the eucalyptus towels, but this sort of stuff, private equity selling stuff to itself, is really common now.

Like we're talking about a lot of money.

Like these sorts of transactions are running at a record pace.

So it just feels like something in the process here is a bit broken.

And I'm wondering whether we need to worry about it.

Katie, when you say that private equity helped break the IPO market, what do you mean just that all the companies that were going to IPO got bought, taken private, and so the industry kind of withered, the IPO industry.

And particularly in the UK as well, private equity firms have bought a lot of listed companies and taken them private.

And so what you have is a rapidly shrinking public stock market.

And that just undermines the ecosystem more broadly.

And that's a kind of global issue.

Antoine is making his skeptical face here.

Well, there are two points.

There are two points.

First, to your point, private equity-owned companies are more leveraged.

So when you take them to go public, they're rightly received skeptically by the investment community because

they'll have, say, five times their operating cash flow as debt.

That's pretty high.

Your average public company is probably, you know,

three times or so.

And then the other point, why is the market market doing so well?

Well, there's no Mag 7 in private equity.

Fair enough, fair enough.

But then to the counter, you know, once you get out of the Mag 7, or maybe it's the Mag 11, you know, however many, there are a lot of miserable companies on public markets.

And so even as this industry is stuck, every year we continue to see the stock market shrink.

And so the public companies are still making the judgment that I would rather find a single buyer, a consortium of buyers who understand my business fundamentally, and we will go dark, we will go private, and we will come up with a strategy amongst ourselves instead of trying to sort of foster this multiple on the public market.

So it does point to a structural problem in the public market that is part of the reason the private markets are so stuck.

But let me so what people always say to me about this is, look, you've got private private equity firms that don't want to list their companies on the stock market unless they're pretty sure they'll get good money for it.

And then you've got public stock investors who are like, look, I'll give you some money for it, but I'm not going to give you good money for it.

And you've got this gap in expectations between what private equity thinks that companies should be worth and what public markets think that companies should be worth.

And people keep telling me, don't worry, these two things are going to come together.

We're going to close that gap and everyone's going to come to an understanding about what these businesses are worth.

And there's a a great pipeline.

It's always a bloody pipeline with these people.

There's loads of these privately held companies that are just circling the airport waiting for their slot to land.

And any day now, they're all going to start launching on public markets and they're going to go brilliantly.

And that's going to encourage more companies to do it.

And everybody's going to be happy.

People keep telling me this is going to happen next year.

They told me that last year and the year before that as well.

It's always just around the corner.

What actually breaks this constipation, as I sort of like to think of it?

Because that's basically been the last four or five years for private equity, and now they need to turn in their homework.

So they need to return the money to their investors.

Their investors will find out what their investments were actually worth, and they have to do it now because

investors have stopped giving them new money until the cigar box gets refilled.

And

so that's what's happening.

And the other thing is, there's a logical reason people have held on for a while.

There was a pandemic.

Then there were interest rate hikes.

Then there were trade wars.

And everyone is playing a bit of a game of chicken and they don't want to capitulate right before Trump bullies the Fed into bashing interest rates down back towards 0% or 2% or whatever.

And everything's gravy again because that's the lesson they learned in the 2008 crisis.

Meaning, wait.

Wait as long as you can.

This is all kind of an equity option in some ways.

And you don't want to kind of capitulate when you see, you know, the economy sort of still holding up and you feel deeply interest rates are going down.

Can I offer a different theory?

And you two can tell me whether you think this is right.

I think what happened can be explained more simply as follows.

20% a year compound rate of return is not happening anymore.

That level of return is an artifact of when the private equity industry was younger and there were juicier targets out there, companies that were managed worse and were more susceptible to the magic of financial engineering and when rates were lower and so forth and so on.

And so this is a long process of realizing that you're not going to do double the rate of return of public markets anymore.

It's not going to happen.

And one way or another,

hard way or easy way, the industry is going to figure it out and investors are going to figure it out.

It's even worse than that a little bit.

It's that plus the most amount of money in the private equity industry's history was invested at the tail end of the zero rate interest rate world.

Then that flipped.

They're holding on to this record sum of hundreds of billions or trillions of dollars that were invested at the absolute wrong time.

And so that's also what's causing the hold.

They need to kind of grow these businesses out of sort of an underwriting mistake that was done in 2020 or 2021 because all the math depended on rates being real interest rates being like zero and now real interest rates are whatever they are and that just screws up your math that screws up your route to 20% compound returns.

And people weren't betting rates were going to stay at zero, but they thought it was going to be two and a half percent, not five.

And so that's what really got them.

Yeah.

So Antoine, let me ask you, right?

So private equity is finding it can't list these companies on public markets.

It can't find other industry buyers for companies that are on their portfolio.

It strikes me as no coincidence that all of a sudden people are talking about democratizing private equity and there's lots of efforts to get mom-and-pop retail investors involved in private equity and to put it into people's retirement plans and this and that.

Is it too cynical to wonder whether the industry is looking for naive buyers of this stuff because they can't find any other way out.

I think people should absolutely be on high alert for that.

There's no question about it.

And the other quick point is that these retail funds are, quote, evergreen funds.

So they're going to be making investments where they actually don't feel they need to sell.

The idea is going to be to compound them like Warren Buffett would.

But that means there's no cigar box accounting, which was the beauty of the industry.

You hand over money, you get it back 10 years later.

Now Now you're going to be relying on a lot of subjective judgments like valuations and sort of the marks that we all sort of are skeptical of sometimes.

Antoine, thank you for giving all of us something new to worry about.

Please come again with your special brand of misery onto this show, but we're going to be back in just one sec with Longshaw.

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Oakie doke, it's time for Long Short, that part of the show where we all go long, a thing we love, or short, a thing we hate.

Rob, why don't you go first?

I've got a pair trade.

I am long

the recently departed Robert Redford, who was a wonderful actor and an underrated director, and I had loads of time for him.

However,

I am short

dressing like Robert Redford because Robert Redford had a real way with casual clothes with a blazer over jeans or a shirt unbuttoned to the waist.

And the mistake some men make is to think that if they dress like Robert Redford, they will look like Robert Redford, which they will not.

So

it's one.

Very few men indeed.

So be careful.

Admire Robert Redford all you want.

Be careful emulating his style.

Good advice there.

I am going to be long Mario Draghi.

So it's a year since he put out his big report into European competitiveness, and he's just made a speech saying, one year on, Europe is in a harder place.

vulnerabilities are mounting.

Basically, people are not listening to the big man.

Listen to Mario Draghi and get on with it.

That's what I say.

Antoine, what about you?

Well, if you think the teeth gnashing that we just talked about is here to stay, there are advisors who get paid very handsomely to keep the music going.

So I'm along the well-paid advisory firms Evercore, PJT, and Houlihan Loki.

They get fees every time there's a continuation fund that comes down the pike.

And if it all goes south, they have great restructuring businesses to take out the trash.

The investment bankers always win.

That is the lesson of this story.

Beautiful.

I'm so glad it's all worked out for them.

You know, they need a break now and then.

Antoine, thanks for coming on.

Again, thanks for giving us all something new to worry about.

Listeners, sorry about that.

You now worried about something that you previously may or may not have been aware even existed.

But please don't let that put you off.

Tuning in again when we're back in your ears on Thursday.

Unhedged is produced by Jake Harper and edited by Brian Erstadt.

Our executive producer is Jacob Goldstein.

TopaVores is the FT's acting co-head of audio.

Special thanks to Laura Clark, Alistair Mackey, Greta Cohn and Natalie Sadler.

FT Premium subscribers can get the Unhedged newsletter for free.

A 30-day free trial is available to everyone else.

Just go to ft.com slash unhedged offer.

I'm Katie Martin.

Thanks for listening.