Professor Glenn A. Okun
The $3.2 billion pile of portfolio companies that remain stuck in the hands of private equity funds has not gone unnoticed in a recent Bain report. The consulting firm has described the problems previously identified by the Rapid Capitalist, including historic high valuation multiples on investment, elevated interest rates on financings and a dearth of attractively priced exit opportunities (see https://therabidcapitalist.com/2024/02/12/private-equity-gets-kicked-by-the-can/) as well as the threats to future investment returns (see https://therabidcapitalist.com/2023/12/26/private-equity-performance-collapse/).
The threat of greatest concern for general and limited partners alike is the impossibility of a return to the economic and financial conditions required for attractive private equity fund performance. These factors are the fuel of fruitful financial engineering.
Private equity investment returns rely on successful financial engineering. Opportunistic acquisition and exit activity combined with refinancing driven cash flow distributions account for the bulk of private equity fund returns.
Value-added mergers and acquisitions and refinancings are only possible in a climate of declining interest rates. Valuation multiples and refinancing proceeds expand when interest rates fall, creating lucrative sales proceeds and dividend distributions .
The history of private equity investing success has coincided with the interest rate easing cycle initiated by Paul Volcker, chairman of the Federal Reserve, in the early 1980s. This cycle ended in 2021.
Private equity partisans argue that strong private equity returns can be provided by organic growth and cost efficiency initiatives. An operational focus can add value to fund outcomes but cannot replace the historic contribution of financial engineering.
Revenue growth and margin expansion are constrained in the near-maturity and maturity stage companies in which private equity must invest. This is the sole stage of the lifecycle of the firm where businesses generate the reliable cash flows required to service the debt necessary for acceptable investment returns. Unfortunately, mature companies have limited sales growth and cost efficiency potential.
Under current and intermediate term conditions, investors must expect muted private equity returns. Historically attractive performance will reappear when general partners can ride a lengthy declining yield curve. The several hundred basis points of interest rate easing that will be provided over the next few years is no substitute for the four-decade long delivery of two thousand basis points of interest rate relief that fueled the growth of the asset class.
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