The private-equity industry has been a wonder, a massive growth and profit machine that has made the rich richer, flattered the returns of pension and sovereign funds and thrust star tech companies onto the stock market. Their fuel is cheap debt and lots of it, and the returns have been awe-inspiring.
But the private-equity party may be coming to an end.
The initial public offerings of the ride-hailing services Lyft Inc. and Uber Technologies Inc. were flops. Lyft, which joined Nasdaq in late March, is down a quarter from its IPO price. Uber, which went public May 10 on the New York Stock Exchange, shed 18 per cent in its first two days of trading, a dream come true for the short-sellers. The owners of WeWork Cos. Inc., another money-losing, IPO-bound private-equity wonder, are suddenly in a bad mood.
Private equity has been around for decades but really took off not long after the 2008 financial crisis, when the smart money realized the public markets could vaporize fortunes overnight and that the new era of ultracheap debt – thank you, U.S. Federal Reserve and European Central Bank – could create the magic money formula. Since 2014 alone, private-equity funds have raised about US$3.7-trillion of capital.
The business model was simple: Buy companies old and new, proven and unproven, load them up with massive amounts of debt, all the better to boost returns on equity and pay the new owners fat, pre-IPO dividends, and flog them on the stock market for lavish returns.
The past five years have been especially bountiful for the private-equity gangs. Bain & Co.’s 2019 private-equity report said total buyout value – a favoured metric in private equity – rose 10 per cent, to US$582-billion, “capping the strongest five-year run in the industry’s history.” Private-equity returns have generally hovered in the mid-teens – spectacular compared with stock-market returns. Last year, the S&P 500’s return was minus-4.4 per cent, although its performance was far better in 2016 and 2017.
What’s not to like? More than a little, as it turns out.
The first negative aspect of the debt-charged buyout craze is that it may have backfired on the Fed and the ECB, which had dropped rates in good part to stoke inflation (inflation went negative in early 2016 in Europe). Private companies that were loaded to the rafters in debt had to cut costs, which meant employees had to be terminated while pay raises for the survivors pretty much disappeared even as the owners of the companies grew wealthier by the day. Badly paid or jobless workers put disinflationary pressure on the economy.
Take Uber. It exists to undercut the licensed taxis, which is disinflationary. It pays its drivers little and is resisting raising their pay, even though some are going on strike to protest their working conditions, because giving them more would require higher fares and reduce Uber’s market share. Repeat with Lyft and other companies whose private-equity owners obsess about maximizing returns.
The second negative aspect is the debt itself. While debt is unusually cheap, stuff enough of it into any company and its margin for error disappears. A rise in interest rates, a market fall, an economic downturn – each could trigger a negative equity scenario.
Private-equity players have been adding leverage over the years, to the point some companies had death or near-death experiences.
Take the sorry story of Toys "R" Us, once the world’s biggest toy retailer. Three big private-equity firms – KKR & Co., Bain Capital and Vornado Realty Trust – bought the company in 2005 and boosted the company’s debt from US$1.9-billion to US$5-billion. The excessive leverage reduced the company’s financial flexibility to almost nothing; most of the operating profit went to servicing the debt, leaving little to revamp the tired stores. Toys "R" Us went bankrupt in 2017 and liquidated its U.S. operations last year, putting 30,000 employees out of work. It is only one of several big retailers that collapsed under the weight of crazy amounts of debt. (Toys "R" Us Canada continues under new owner Fairfax Financial Holdings Ltd.)
The Bain report says private-equity players are loading up their deals with ever-greater amounts of debt, even though U.S. interest rates have climbed. The report notes that, in the years after the 2008 financial crisis, regulators discouraged debt multiples that reached six times the target companies’ earnings before interest, taxes, depreciation and amortization (EBITDA – essentially operating profits).
Enter Donald Trump and his regulatory-lite style. Bain says that “in the Trump era’s more relaxed regulatory environment,” the share of deals with debt multiples of seven times EBTIDA has climbed to 40 per cent of the total. Some may be higher, depending on assumptions made on future profits, and you can bet those assumptions are becoming more bullish. In other words, the equity cushion is getting smaller and the risks higher.
It’s hard to say private equity is in a bubble – bubbles are only identified after they burst. But exceedingly high valuations and leverage ratios of the businesses targeted by private-equity funds positively shouts that the market is getting out of whack. The ugly IPOs of Lyft and Uber are powerful hints of trouble to come.
Eric Reguly