Longtime Monarch Private Equity Gets Its Crown Knocked Off

Art by Alex Gora

The perennial darling of big investors, private equity has offered the promises of tasty returns and diversification from prosaic stocks and bonds. Too bad that, just as it did 12 years ago in the financial crisis, the mighty PE engine is entering a slump. 

“This is going to be a bad year for” general partners and limited partners of PE funds, said John Bowman, senior managing director at the Chartered Alternative Investment Analyst (CAIA) Association. 

Exiting deals, where a PE fund sells off a portfolio company for a handsome profit, will be an iffy proposition amid a vicious recession with no end in sight to the pandemic. This means their general partners (the top managers who run these shops) won’t be able to collect the typical 20% of the profit from selling a company.

While buyout prices surely will be lower this year, the ability to eyeball a fresh takeover target is difficult in a time of social distancing, at least in locales under lockdown. Raising money for new funds will be problematical when investors need to husband cash.

On the positive side, many PE funds have a lot of extra capital on the books, known in the trade as “dry powder,” that they usually deploy to buy out target companies. Now, they can use dry powder to help limping portfolio companies or to just wait out the bad times.

Those brave souls who buy distressed companies will find that, amid economic devastation, the pickings will be plentiful. Provided they can still perform some kind of due diligence on buyout prospects, that is. And, of course, PE firms will continue to rake in the 1.5% to 2% in annual management fees for overseeing a stable of companies. One caveat: A drop in their portfolios’ asset base will diminish the fee take.

Tellingly, the PE industry leaders—Apollo Global Management, Blackstone Group, KKR, and Carlyle Group—had large losses in this year’s first quarter. Red ink for the quartet’s holdings (actually a tally of their paper value, not a cash decline) was $5.6 billion.

Nonetheless, their losses weren’t markedly worse than those of the public markets. Blackstone and Apollo each reported negative 21.6% for the year’s first three months, close to the S&P 500’s 20% decline. Carlyle and KKR, with minimal exposure to hard-hit industries such as energy and commercial aviation, were down just 8% and 12%, respectively. Blackstone had a heavy energy presence, and Apollo was hurt when one of its companies, insurer Athene Holdings, got slammed by credit market turbulence.

Still, these dips reflected only one down month, March. Upcoming is an entire three months of the second quarter, which is sure to be a wipeout.

Result: 2020’s watchword is caution. Consider recent capital calls, where funds ask their investors for a portion of the money they pledged. In March and April, these were mainly focused on shoring up portfolio company balance sheets and paying for deals that may have been signed months before, not to purchase new platform businesses, said Brian Rodde, co-head of private equity at Makena Capital.

The Glory That Was

Oh, what a lovely ride it has been for PE. Over the past four years, data provider Preqin says, PE managers corralled more than $500 billion to invest. Their total assets under management (AUM) reached a record $4.1 trillion. Last year, the funds attained their highest levels on the number of deals (5,433) and their value ($755 billion), Pitchbook calculates.

The industry’s $1.5 trillion in cash on hand, aka dry powder, is also the largest on record—and more than double what it was in 2015, Preqin notes. “The amount of dry powder is almost as big as the first stimulus program from the US government,” CAIA’s Bowman said.

The allure of private equity is that it’s a long-term investment, resting on a collection of well-chosen targets whose performance can be improved, thanks to the hard-eyed management of the funds’ smart people. Fat is cut. Unneeded subsidiaries are jettisoned. Corporate strategy is sharpened or redirected.

A lot of public target companies are happy to be bought. In addition to a nice pay day, if the target’s executives stay on, their lives may well be easier as a private business. Then, Bowman said, they can avoid “the headaches of public markets, the regulations, the costs, the activists.”

Despite a lot of catcalls from critics who liken PE operators to ghouls for their habit of dumping employees, the buyout boys and girls largely have delivered good returns. Through 2017, a PitchBook study indicates, PE did better than the S&P 500 index over one year and 10 years, but just missed for five years. The breakdown: 17.8% for PE compared with 13.6% for the index over one year, 12.8% versus 13.7% for five years annually, and 12.9% against 9.1% for 10 years.

The 2018 stock market down year (the S&P 500 lost 4.7%), driven by worries over the China trade war and rising interest rates, was a good one for private equity. That year, its returns surged 18%, McKinsey & Co. says. Given the strong stock market in 2019, little doubt exists that PE did well then.

From the start of the century, PE’s rise was almost double that of the S&P 500, a Preqin study shows. Small wonder that the success of private equity has been a boon for its practitioners, notably Blackstone’s Stephen Schwarzman (net worth, via Forbes’ estimate: $18.4 billion) and Apollo’s Leon Black ($8 billion).

Pensions and other institutions have been stalwart supporters of private equity. With low single-digit returns from bonds, once the backbone of institutions’ finances, the enticement of PE has been irresistible. In 2000, the 10-year Treasury sported a 6.7% yield, and now that has shrunk to 0.7%. This means that the benchmark bond, the ultimate in safety, is of little help in delivering many pension plans’ 7%-plus annual return objectives.

A sizable 91% of the public pension programs were in private equity, and PE constituted  8.7% of public pension portfolios, the American Investment Council reported in 2018. The public pension plans with the biggest PE investments are the California Public Employees’ Retirement System (CalPERS) with $27.2 billion, the Teacher Retirement System of Texas (TRS) ($21.2 billion), the Washington State Investment Board (WSIB) ($20.92 billion), the California State Teachers’ Retirement System (CalSTRS) ($18.3 billion), and the New York State Common Retirement Fund (NYSCRF) ($17.5 billion).

Reversal of Fortune

What a difference a couple of months makes. In February, before the coronavirus really took hold, things appeared pretty decent for PE, although some expected a small downturn amid a mild economic slowdown. In May, however, look for deal volume to contract, as PE managers grow leery. “They’re uncomfortable doing a deal,” Makena’s Rodde said, if for instance “they can’t tour facilities or meet with management teams in person.”

PE acquisition teams like to swarm over an acquisition target’s books and inspect its operations with a jeweler’s eye. Unfortunately, target companies lately “are shut down so our clients can’t do on-site due diligence,” said Matt Heinz, senior managing director at Aon Transaction Solutions, a consultant to private equity.

Odds are strong that an acquisition done with minimal or no due diligence will end up cursed. The primo example, and one not involving a PE firm, was Bank of America’s rushed buyout of Countrywide Financial. BofA thought the subprime mortgage was a screaming bargain in the 2008 housing plunge. Countrywide’s toxic mortgages ended up almost destroying one of the nation’s major banks.

Certainly, no amount of scrutiny guarantees a triumphant buyout. Classic case in point: KKR’s 1988 takeover of RJR Nabisco, which foundered under too much debt and a collapse in cigarettes’ popularity.

The new PE caution was on display with Sycamore Partners’ recent backing out of its deal to buy a $525 million controlling stake in Victoria’s Secret. The virus had prompted the lingerie seller to shutter its stores, and Sycamore had second thoughts. After a flurry of legal action, the chain’s parent, L Brands, agreed to end the transaction.

The chief way private equity firms make their money is through “exits”: selling companies in their inventory, either to another PE firm, a corporation in need of a good add-on, or the public. If a portfolio company’s value sinks 20% to 30%, PE operators usually don’t want to peddle it. They wouldn’t get much of a price from strategic buyers. And taking a company public in this unsettled market environment is a non-starter.

“Those funds looking to make exits in the next 12 to 24 months will be facing a lower pricing environment,” Preqin said in a release, “while vehicles currently operating their portfolios will see disruption to their holdings’ industries.”

Thus, for PE investors, known as limited partners, the prospect for getting decent or any distributions up ahead is bleak. Distributions to US private equity limited partners fell 72% in March, consulting outfit Colmore found. Overall, Pitchbook expects distributions to be halved during the COVID-19 crisis.

Beyond this problem, a lot of deals were done with heavy debt, which will make them tougher to divest. PE operations by their nature use debt to magnify buying power, hence the 1980s term that gained renown in the KKR-RJR episode, leveraged buyout. Multiples are higher of late as more leverage was loaded on amid the recent PE boom, due to increased competition and low, low interest rates.

Some 40% of PE deals last year had debt exceeding seven times earnings before interest, taxes, depreciation and amortization, or EBITDA, Bain & Co. research shows, a lot higher than during the last buyout frenzy, before the 2008 crisis.

The longer a PE fund holds onto a portfolio company, the more likely it’ll deliver sub-par returns. No one wants a heavily debt-weighted business, particularly when the economic climate is rotten and the company is scrambling to survive. “They’ve passed the fruit around and squeezed all the juice out of it,” CAIA’s Bowman said.

With recent buyouts at the not uncommon level of 11 times EBITDA, watch out. Pitchbook warns that the eventual exit profits will slip compared to those with EBITDA multiples of nine or less, which prevailed before 2013. As leverage rises, the probability of financial distress does, too, with such sky-high buyouts up to 10 times more probable to declare bankruptcy than publicly traded companies.

Raising new capital will be a lot tougher this year. In January, Platinum Equity Partners garnered $10 billion for its largest fund yet, but most believe that will be 2020’s high water mark.

Some Positive Glimmerings

But then … there’s all that dry powder, money that’s already sitting on PE firms’ books. One place to use it is on distressed investments—good companies down on their luck, in need of some TLC and a capital infusion. Luck, to be sure, has fled some companies that before the virus were doing fine.

Such is the case with Expedia Group, the online booking service that has been walloped by travel restrictions. Solidly profitable through 2019, Expedia is expected to show a loss when it reports its first quarter on May 20. The company has lost half its market value since January.

So private equity is sniffing around. Apollo and fellow PE-er Silver Lake have proposed buying a $1.2 billion stake in Expedia. In March, Apollo’s top private equity executives, Matt Nord and David Sambur, told investors that the pandemic-induced market disruption gives them a “time to shine.”

What is the future of PE after the COVID-19 crisis abates, whenever that comes? “It’s hard to say, as we’ve had three 100-year floods in the last 20 years,” Aon’s Heinz said. “But with all the dry powder they have, there could be a feeding frenzy. Memories are short.”

In the meantime, the risk level of deals is now climbing higher because the course of the virus and its effect on potential targets are formidable question marks. “Nobody knows what’s around the corner,” Makena’s Rodde said. The upshot: PE firms “aren’t likely to be racing to push capital out the door.”

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