Private Equity Is Over-Leveraged, Illiquid And Might’ve Outdone Themselves As They Hold A Record 28,000+ Companies Worth $3 TRILLION

Private Equity is playing an interesting and risky game with the world’s economy that is going unnoticed. This section would be a bit lengthy and technical but I will do my best to keep it simple. Rising Interest rates, record-low IPOs, an increasingly uncertain market an overused bankruptcy strategy, and debt-laden companies have all come together to bring the private equities returns down to 11% from 25% to disgruntled investors and this is a very dangerous game they are playing

Private Equity (PE) is a broad classification of investing that just means putting money into companies that are not publicly listed on any securities exchange. Think Shark Tank, Dragons Den and Venture Capitalists that inject capital into companies to help them grow, these are all types of PE deals. Also if you have ever given money to your cousin who has a business idea that is sure to 10x in exchange for part ownership of the business or profits, you are technically a PE investor. In this situation, the type of PE I would be addressing is the Buyout funds, they raise billions from pension funds, investment pools and other wealthy investors to buy out and control entire companies. The thought process is, like a house-flipper, use their experience to make improvements, cut down on costs increase sales and eventually sell the company for a profit and from those profits bring returns to their investors in theory. From start to finish this process takes about 7–10 years. The problem is the last part, the selling off of the company or regaining back that capital which has slowed tremendously

Another thing to note is the fact that interest rates were incredibly low in 2022–2023 and have now almost tripled. As such these Buyout funds will acquire a company like WeWork, install a new CEO and have that new CEO get a loan from a bank for WeWork against its valuation and its profits. However, instead of using the capital to reinvest in the business through advertising and/or growth, they have that new CEO pay the entire sum of the loan to the PE firm and the firm would use some of that capital to give returns to their investors and use the rest of it to buyout another company and repeat the same process as many times as they can leaving more companies saddled with incredible debts as the PE Firm is not responsible for the debt. This is a simplification of the term “Leveraged Buyout” or and LBO. These companies could manage their repayment schemes as interest rates were low, but now that it has more than tripled businesses have no choice but to file for bankruptcy, even a 1% increase might be worth hundreds of millions of dollars in additional cost to the repayment of the loan, this was the reason why in 2023 the highest number of bankruptcy filings were recorded, SVB, WeWork and Vice Media were all amongst the businesses that filed last year.

Assuming I haven’t lost you yet, it gets much worse. Now that PE firms have practically bought up all they could and aren’t borrowing anymore because the rates have gone up, they must still make their returns to their investors, and investors do not like getting paid less than what they’re used to. The firms, knowing they cannot use the LBO vehicle, and cannot increase the liability of the firm itself but still need Liquidity, introduced NAV financing, or Net Asset Value (the net value of an investment fund’s assets minus its liabilities, divided by the number of shares outstanding) Financing. A group of companies that a PE firm owns or controls is called a portfolio, a NAV loan, or NAV Financing in simple terms occurs when a firm takes a loan from a bank and puts up their stake in or shares of a company or companies within their portfolio as collateral, which lays the onus of paying back these loans on the company and not the PE Firm.

Now to make sense of all this, if you cannot really make out how this is a problem I’ll explain. Eventually, companies will start to go belly up, causing an incredible number of job losses, and would be unable to pay back the loans given which in turn will make banks weary of approving NAV loans, this increases the liquidity issue, causing investors to pull their money, furthering the liquidity issue, causing more companies to go belly up, and a vicious cycle ensues. With PE firms holding 28,000+ companies, all it takes is a few major lenders halting their funding.

It seems like we are not there yet as Goldman announced their $300Bn private credit portfolio expansion and The traditional initial public offering (IPO) exit route is starting to light up in green, after a long time with barely a flicker. European companies have raised over $3 billion in IPOs since January, more than double the amount from the same time last year. [Bloomberg]