The private equity industry -- excluding VC, which represents a small fraction of total capital raised -- relies extensively on debt (LBOs, debt-financed infrastructure deals, debt-financed real estate deals, etc.), i.e., borrowing to juice returns. It's not a coincidence that the industry was born in the 1980's, when interest rates in the US began declining, after the Fed had increased them to combat high inflation in the 1970's. Ever since, for four decades now, interest rates have only declined and declined, in fits and starts, making life easier and easier for borrowers of all kinds:
Many private equity deals that arguably were economically viable when the 10-year treasury's annual yield was ~0.6%, less than a year ago, may not be viable now that the 10-year treasury's annual yield is ~3%, and are likely to suffer financial distress if interest rates rise further -- say, 10-year treasury yields of ~5%, ~6%, or more. If that sounds high, keep in mind that the last time the Fed had to deal with high inflation, in the 1970's, the 10-year treasury yield rose to a peak of ~16%!
Over the same past four decades, valuation multiples have only risen and risen, in fits and starts, making life easier and easier for those who make money by buying businesses, holding them for a while, and selling them down the road. For example, here's the ratio of US stock market capitalization to the size of the US economy (GDP):
The rise in valuation multiples over the past four decades makes sense, given that the net present value of any business is inversely proportional to the discount rate used to value its future profits, and discount rates are equal to prevailing long-term treasury rates plus a premium. If interest rates continue to rise, valuation multiples are bound to decline too.
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EDITS: Changed language in response to comments below so it better reflects what I meant to write in the first place.
Most LBOs aren’t really that interest rate sensitive, let’s say you buy a company for $100m dollars 12x EBITDA, and 15x unlevered free cash flow ($7m), you would have put $50m of non amort. debt in the business @ 3%, so had a $1.5m interest payment. Lets say that doubles to $3m, earnings would have to be cut in half to not be able to service debt…
[EDIT: the data in this paragraph is WRONG! See comment below.] 12x EBITDA? Unlikely. According to the article, the average valuation multiple for US deals to take firms private is 19.3x EBITDA.
A 3% rate for a leveraged entity? Unlikely. Current high-yield spreads are in the neighborhood of 500-600bp, on top of treasury rates.
So, you'd need 60% more debt (19.3/12) to keep the same capital structure [EDIT: this last sentence is WRONG! The amount of debt needed would be the same, because the correct EV/EBITDA multiple is 12.3x. See comment below.], and the debt would be 2-3x more expensive, leaving much less margin for a downside scenario, say, in the event of a prolonged recession, rising rates, and/or declining valuation multiples. If all three of those things happen at the same time, things could get... ugly.
> According to the article, the average valuation multiple for US deals to take firms private is 19.3x EBITDA.
That's on a PIPE, which is a small subsection of all PE buyouts. Average multiples for ALL buyouts is 12.3x in NA:
Average buyout multiples in 2021 rose 9% to 12.3x in North
America, and, despite a slight decline, still stood at a lofty 11.9x in Europe (see Figure 14).
With regards to your comment on the rates, most LBOs are done with floating rate loans/ bank loans/levers loans, as such they trade at a spread over libor/sofr, which chops ~3% off your interest rate…
IRRs have been waning the last few years anyway, to the point folks will look at 12.5%. There is a lot of money chasing PE allocations. Of course top quartile funds will just pull further away from the pack.
Not really, that rule of thumb is that if you can grow EBITDA at higher percentage than the EBITDA multiple you bought at, thing will just work out fine (e.g. buy at 20x need 20% cagr on earning over the next 5 years)
There was a recent Economist article that said that 6% of the performance in PE is driven by earnings growth. It’s a Ponzi scheme built on debt because PE has so much money that they just trade around companies at higher multiples. Lol imagine believing in synergies, or that the trash you guys make is somewhat legitimate at all. Cutting shit to the bone and sending it to the next guy isn’t good business.
Enjoy the money and the carried interest loophole while it lasts. Community Health Systems? Dex Media? I’m not one of the fools that will buy it. Maybe it helps you sleep at night or whatever but if rates continue to spike, all the trash adjusted EBITDA nonsense will all die and you guys will lose your shirts.
LBOs haven’t been the defining structure of PE for a while now, though leverage is still a key ingredient. The massive growth of the “PE industry” over the last decade has really been on the credit side (which does include equity plays, e.g., in real assets and distressed debt that leads to equity positions) despite the low interest rate environment.
Do you happen to know if “private credit” (I don’t know if that is the actual correct term) is a big part of PE’s investments? I stumbled upon mentions of it more and more during the last 2 years (I’d say) and it kind of gave me some “this can’t be structurally right”-vibes. Or maybe that is just a very small market, comparatively speaking, and I’m talking bs, hence my question.
It's absolutely part of the investment structure. It's no different from buying a house that you would rent out for yield. If your yield outpaces the costs (maintenance, taxes, utilities, AND the mortgage rate) then you are basically have an arbitrage. This is no different from what PE does and is why they typically leverage ~50% of the acquisition price.
to nitpick, neither yield outpacing costs nor PE is arbitrage. arbitrage is structurally zero-risk, while those other cases have relatively small but non-zero risk, since yield, costs, interest rates, regulations, etc. can change over the lifetime of the deal. arbitrage generally happens due to a mispricing and an opportunity to buy and sell at (approximately) the same time.
Yes, it’s now a major business for the big PE firms (which today are really diversified investment managers) with AUMs that can significantly exceed that of (traditional) corporate PE. But its their credit vehicles that invest in credit. So their corporate PE funds might do buyouts or growth equity or whatever, but won’t generally be direct-lending or buying securitized debt.
> The private equity industry -- excluding VC, which represents a tiny share of total capital raised -- relies extensively on leveraged buyouts (LBOs), i.e., borrowing to juice returns.
Thanks. Yes. I changed "tiny share" to "small fraction," and noted that the industry is much more than LBOs. Note that many other kinds of PE deals -- e.g., infrastructure, real estate, distressed secondary investments -- are done with lots of leverage too.
Regulatory and tax changes in the 1980s created private equity. Declining interest rates juiced it, as has computerization, but the fundamental change was Reagan's policy of financial deregulation and reducing capital gains and marginal rates so that entrepreneurs had more money to invest.
What specific regulatory changes occurred in the 1980s that created PE? KKR, a pioneer of the industry, was started in the '70s and they did a landmark $380 million deal in 1979, which is billions in today's money.
The first LBO was of Orkin Pest Control in 1964 and there were about a half dozen other LBOs in the 60's.
what does this mean if your company is acquired and run by a private equity? will the rising fed rate mean that they are looking to cut out the highest salaries? am I better off not takin a higher salary because that might paint a red target on myself?
It just means that when entity A wants to buy entity B, they have a general 'cost of capital they use to determine whether or not they want to buy something - and it doesn't matter if it's with cash or debt really.
If you're an employee worrying about stuff, well, I wouldn't unless you're the CEO and have the power to make huge investments ...
If you are a very profitable company, i.e. 'cash cow' without a lot of debt, then private equity may be interested in buying your company with heavy borrowing, using the profits to pay for the debt.
Another way to look at it is, the company is not taking enough risk given the price of cash available in the market.
One thing a company might want to do is take on debt and extend the business.
If it's a private company with strong board control, and the shareholders don't want to sell, well, then you don't have to worry.
As for companies that do get acquired, this notion that PE just wants to screw things up short term etc. is a bit bullshit. Burger King was acquired by that famous Brazilian outfit, and they turned the company around. In that case, probably some execs got fired to clear the path for the new vision, but it will vary case by case. The company might get split up into components. Maybe there is a garbage part of the company dragging on revenues. Maybe that supposedly crappy part of the company is actually more 'long term' and killing R&D would hurt the company, but that's surprisingly hard to establish. A lot of R&D is a waste.
With rising interest rates, debt becomes more expensive, and companies have less to worry about getting bought out like this - of course, companies that are carrying debt have a greater burden.
In summary, companies probably need to adjust a bit given interest rates. This is where a good CFO comes in.
If its speculative, then its either going to deliver a multiple of its investment, or just be a cost, but one that may be worth it to explore an opportunity. I doubt that R&D which proves no viable product is feasible, or no market exists, is more wasteful than allowing a business to wither on aging uncompetitive product lines for want of proper R&D.
thanks I feel good now, I almost turned down a 4-bagger offer until I read your comment, but I am a bit wary, the new CFO is a bit of an unknown. am I going to show up on his radar now? I feel like the business can't run without what I built and my maintenance, in-depth knowledge of the critical business processes.
Oh Jesus, get an investment banker to help you with these things, don't worry to much about what random 'me' has to say about it. I mean - it's actually not that complicated at the end of the day once someone becomes 'financially literate' but the underlying conditions of any deal matter 100x more than general patter of VC, PE and interest rates. There are people (investment bankers) who do this day and and day out and it's like riding a bicycle to them. Find one who cares enough to know about the details and doesn't push you into a deal because they want the commission, which will be their big incentive. They may just require a fee. Try your peer network out for that.
All PE overlords are not the same. Learn what the company's style is and base your decision on how they've handled their other investments. Did they gut it and continue to run a husk? Did they buy companies to change leadership and then sell it to be an "add on" to other PE investments? Did they cut costs, load.on a reasonable amount of debt, take it public again and remain on the board and reap the rewards? All that and more could happen, and you will see your future in what has been done to other acquired companies.
Sorry but ain't no way 10 year is going to 5-6%... I'd wager it's very likely peaked at 3.5% and it won't break that again (for this cycle).
Valuation multiples are (relatively) crushed, and I don't think we'll see much more of a multiple compression. What we will see, in both private and public markets, is when businesses adjust their earnings forecasts for the (very likely) impending recession. If you look at Wall Street numbers companies are still forecasting growth pretty every quarter through 2023. Now, that doesn't seem very likely to me.
The deal is, the public markets will overreact as always and sell off harder, but private equity will stay more fairly valued because of it's inherent lack of liquidity (two wrongs make a right).
Oh, I very much hope you're proven right. I mean, almost no one wants higher interest rates -- except the Fed, whose priority is curtailing inflation. I'm not sure anyone can predict rates accurately. Consider that just over a year ago, almost everyone was talking about rates going negative, and look at what actually happened!
I mean I speak out if my ass and don't want to pretend to be the sole arbitrator of truth... I'm far from it. But the odds of the benchmark rate going negative were very slim. The Fed didn't need to counter deflation with interest rates when they could just print print print.
I would love to have heard your thoughts as of 1Q21 on 3.5% using the same inputs.
There were brand-name crossover (I won't call them HFs) folks claiming that we would never see positive inflation ever again (right before that fateful Apr-21 print)
I mean I won't name names, but yeah. Best-fit line on CPI was pointing to below zero within the decade (and a common statement was 'humans see crossing 0 as a major milestone, but numbers do not') and we had already seen deflation more or less happening in Japan [0] Italy [1] Switzerland [2] Greece [3] and other small economies with slow-growing population.
Hell, depending on what you believe about globalization and the nature of capital formation, one can still make a compelling contrarian argument that the developed world will see significant disinflation until we start getting serious about global warming (or global warming gets more serious, which is likely what will come first).
To be fair, none of those 4 countries listed have quite the level of control over their currencies' supplies like the US Federal Reserve.
On the "contrarian argument", I see the case for that having deflationary pressure. However, I believe the Fed will try it's damnedest to prevent deflation, at all costs, for the foreseeable future. I also think the US birth rate will find a floor sometime in the next 20 years, at which point (very hopefully) politicians will have gotten serious about immigration reform.
I agree on the 10-year. We might get Fed Funds above 5%, but the market won't expect that to continue for 10 years. (Mathematically, the 10-year yield should equal the expected average Fed Funds rate over the next ten years).
I disagree that valuations have been crushed. You qualified that with a "relatively". We're lower than at the peak of the bubble of course but Shiller PE is still 30, higher than any time other than the dot-com bubble and the current bubble.
Private equity firms will choose not to write down the value of their assets, but the actual transactable prices will probably drop further than public stocks.
Not sure who 'we' in this situation is, but there are certainly a good portion of lower and middle class people feeling the economic pain through rising cost of every day items. My outlook is that we will eventually see this result in a drop in discretionary spending and that is probably when we might expect to see wide spread layoffs or upticks in unemployment.
a $100/month "tax" due to things like high food and gas prices is actually small compared to unemployment.
oil was over $100/bbl from roughly 2010 through 2014 but the economy kept on going just fine.
if people have jobs and have some discretionary income they can ride out the pain of higher prices through deferring spending. the middle class certainly can do this. its the people who are quite literally paycheck to paycheck who fall behind and wind up making poor choices like payday loans who are really going to be feeling substantial pain right now.
and i don't want to sound like i'm entirely discounting that, but crank unemployment up to 10% and it is going to be those people who wind up even worse off and possibly unemployed and homeless. it can get a whole lot worse for everyone right now.
and yeah, the already comfortable people still feel pretty comfortable at this point and aren't feeling a lot of pain, other than maybe the family has to stick with old iphones this year or something. the economy is objectively much worse when those people are losing their jobs and houses than when they're not. which does not deny the existence of people at the margins of the current economy that are being more severely hurt by prices.
While oil might have hit 100/bbl, gas price still only hit 4$ very briefly and the impact of higher prices was generally limited to that sector. Today we are seeing higher prices across the board.
Depending on what stat you look at, the % of people living paycheck to paycheck is actually pretty large, and only getting larger as prices go up, especially in rent/homeownership space.
But...the labor market is showing some great resiliency, so if that initial domino never falls, we might be able to skirt through with minimal damage by keeping confidence high.
I didn't deny any of the first two sentences there.
The third sentence I think is wildly optimistic. The whole problem is the overhang of jobs and the labor market. What they're really worried about is baristas being able to job hop to find better wages just like SWEs have been able to. The Fed have openly talked about this, the business pages talk about it openly and Musk and Zuckerberg are both almost cheerleading the effort to start punishing workers that they think have had it too good lately.
And that is just going to take economic pain and negative employment numbers. And all the talk of a soft landing for the past few weeks is the same language that was used in 2007. They don't actually have any kind of surgical ways to cool off the economy, what winds up is that they crash it. When they do the proverbial "tides goes out and we see who has been swimming naked" -- which means that structural issues in residential and commercial real estate will be exposed. We never really regulated the banks with any teeth in 2008, so we can assume that people out there are making stupid bets on the economy again which are going to go against them (the 2008 crisis actually proves that the people making those stupid bets will not suffer any personal consequences, so it's reasonable to assume that will happen again).
The Fed will have to continue to raise rates until the labor market fails. At that point shit should get very interesting.
Not overly optimistic on a soft landing either, but I also don't want to become a doomsdayer. My real concern is that this economic unrest is happening in parallel with political unrest, and that just means the fan that the shit will eventually hit has a little more RPMs on it.
These groups of people already have a negative discretionary spending capability, they're not going to swing the markets. The markets don't even really jive with working class/normal citizens anyway.
I don't see any areas of the economy where there will be wide spread layoffs besides crypto markets and even then, those people will be swallowed up elsehwere.
I’m not sure negative employment numbers will have the effect you think they will…
I remember a time in the late 90s when “bad news was good news” - which is to say, bad economic news portends looser monetary policy… which has been the driver of higher equity prices.
That was before the wonders of ~ modern monetary theory ~ though. It’s already so loose I’m not sure what can the government do to combat what’s coming.
I'm not seeing that trend. We haven't even seen down side in pricing or a full downaward trend in in new construction and most of the modern developments are doing mixed developments of retail, business and living spaces.
There were a few % points drop at times - but most of that was supply dynamics and supply pricing.
so much demand for commercial real estate that prices are up 24%
No, they weren't. By 2006 home sales were already down 10%, Homeowner ship was down in 2006 vs 2005, manufactured homes were down 11%, even apartment dweellings were down 2.4% from 2005 and new construction on apartments was down 5.9%.
2006 was nothing but four quarters of constant decline in housing.
We haven't seen quarter after quarter decline yet and leading up to 2008 it was ~3 years of quarter after quarter declines.
What we have seen is huge market corrections and we're now seeing healthy price corrections in real estate and a slowdown in home buying/selling. Job market still showed growth, retirement savings are down over peak, but still largely doing well over trend.
I'd be fine with consumer confidence shrinking to force pricing back down. I see gas is < $4.00 a gallon here in Austin now (yay).
Corrections are great...
The only way we'll see another 2008 is if it turns out the market was fake to begin with. The only fake market i've seen is crypto. If people back out of that, that won't hurt USD much (it could help) and if people re-invest in crypto well then they re-invest in USD for everything necessary to support crypto (markets, electricity, GPUs/ASICs so on and so forth)
The current goal of the Fed is to crush the labor market and create unemployment and remove the ability of workers to have leverage over wages.
They're not worried about high gas prices because they're economists and they understand that commodities prices are cyclical and act as their own brake on the economy.
They're worried about the wages.
Those aren't going to come down without significant pain.
Against a backdrop of a Republican party in a do-nothing congress which has been preaching against bailouts for 14 years with a Democratic president that they'd like nothing better than to hang an economic collapse on.
We're still only just starting to pop the popcorn here.
Very true, but 2020-2021 was unique in that a lot of young, first-time investors were introduced to the stock market via the popularity of Robinhood and meme stocks.
The entire stock market may only be down 20%, but the investors who piled into hot tech stocks like Peloton and Zoom went from thinking the stock market was easy money to thinking that the stock market is a great way to lose most of your money. Even Robinhood went from a trendy young person trading platform to a perceived villain in the span of a couple years.
The stock market that you see as a seasoned passive investor is completely different than the boom and bust meme stock market that many young people were introduced to recently. I don’t know what the long term effects will be on those who were burned in the exuberance and ensuing crash.
When rates go up, bonds become more useful as an investment.
When the 1-year US Treasury was yielding 0.2% earlier this year, it was a bad idea to buy 1Y treasuries (and most other treasuries). Today, the 1Y is 2.87%, and suddenly a whole slew of investors just won't want to invest into shady high-risk companies anymore (Hey look, US Treasuries are yielding good values again. Lets buy those instead).
The people who did buy 0.2% 1Y treasuries earlier this year (or worse, 10Y or 30Y treasuries) have lost a lot of value due to these higher interest rates.
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Case in point: the 1Y US Bond is literally a better rate than my 15Y mortgage. It makes more sense to buy 1Y bonds than for me to pay off my mortgage right now (ignoring tax issues of course)
Equity and debt. In 2000, 2008 and Covid, bonds all heavily rallied while stocks were selling off. That's the reason the 60/40 stocks/bonds portfolio is the cornerstone of modern portfolio management. Historically one tends to hedge the other, cushioning pain on the way down.
2022 is unique in that both stocks and bonds have simultaneously nosedived in a synchronized a fall. We've had worse equity selloffs. We've had worse treasury selloffs. But together, this year has been historically unprecedented bad performance for the 60/40 portfolio.
You think we've reached bottom? Given the various global economic shocks we've already experienced and are likely to experience later this year, a long, relatively slow bear market decline is more likely than one giant drop.
Keep in mind Russia is only starting to cut off Western Europe (which is only starting to cut off itself), so oil and gas prices still have lots of room to go up if Putin doesn't relent (which he won't). Also we've yet to price in impacts to food from the global fertilizer shortage.
And those are just the obvious 1st order effects in the pipeline. The last time wheat prices went through the roof in North Africa it kicked off the Arab Spring and subsequent Syrian Civil War as side effects. There's going to be all sorts of fun coming out of this year, and I imagine a lot of stocks reliant on global supply chains are going to be ground down by hit after hit after hit.
That's not even touching on domestic demand destruction and interest rates.
In my experience we’ve hit bottom when everyone agrees we haven’t yet hit bottom. Which seems to be around now. In other words everyone who was going to sell has already sold. Unless more surprise bad news comes out.
If everyone agreed we haven't yet hit bottom, we wouldn't be having this conversation. You just argued that we've hit bottom because everyone agrees we haven't yet hit bottom.
It's like how on the cryptocurrency subs everyone's always debating whether we're in crypto-winter yet. Having been through 3 crypto boom/bust cycles, we aren't in crypto-winter, because people stop posting on r/cryptocurrency when it's real crypto-winter. It's the same with other markets: it's not about sentiment, it's about abandonment. When we're in a real bear market, everybody forgets about their stock portfolios and gets a real job because they need the money to survive.
That's assuming you can time the market based on what people are saying... which may work to predict short-term outlook but will have no bearing on what happens in the world next week (or month).
i expect a secular change as rates increase and all sorts of things that worked in a declining interest rate environment stop working, coupled with increasing global trade issues
There are short term effects and long term effects. The short term effect is basically a lot of uncertainty, supply chain issues, and the market re-adjusting to not being able to depend on Russian energy exports. Chaos in other words. Putin's ability to induce more chaos is however declining. Except for going nuclear and starting WW III, he's basically played most of the cards he had. And given how his army performs in the Ukraine, that seems ill advised.
The long term effect is enormous investments in energy and defense spending. E.g. Germany just announced enormous public spending on both. That's after decades of not doing much public spending at all. Other countries are likewise accelerating investments on both fronts. That is a lot of money that is flowing into the economy in the next years. And also a classical recipe for boosting economic growth. We're only a few months into this crisis and it has already unlocked hundreds of billions of funding in Germany alone. Normally, spending that big is going to have an impact on economies. There are companies that will benefit from this. And there are effects on employment, etc.
Investors of course are a mixed bag of headless chickens, snake oil sellers, amateurs and the occasional level headed person with a bit longer view on things. I'd offer advice, but I don't qualify as anything more than an absolute amateur. But the one thing I know is that the short term behavior of stock markets is perplexing and irrational. I wouldn't read too much into it other than that "there's a thing going on and it's impacting the stock market". I would not expect anything less given the thing that is going on. What matters is what happens when that thing is in the past.
IMHO, this situation is a blessing in disguise. It got world + dog moving a lot more aggressively on cutting their dependence on fossil fuels. I think that's a good thing. Going cold turkey on Russian gas is going to suck for a lot of countries short term but the current situation simply leaves no other choice. High prices are a great incentive for moving quickly. The good news is that there are companies itching to step in the void with solutions and they now have the full attention of investors and governments with very deep pockets.
Keep in mind that at 10% inflation in the US, 20% inflation worldwide, nominal earnings will probably be increasing in most companies. And eventually the stock market will build the money devaluation into the prices (i.e. nominal stock prices will go up)
So while the market might only be down 25% which isn't the biggest drop ever, 10-20% inflation on top that makes the actual drop larger. It also might mean the bottom in closer than it would normally be.
> Keep in mind Russia is only starting to cut off Western Europe (which is only starting to cut off itself), so oil and gas prices still have lots of room to go up if Putin doesn't relent (which he won't).
> Also we've yet to price in impacts to food from the global fertilizer shortage.
The US at least can protect itself from rising prices by prohibiting oil and food exports and thus increase domestic supply - they are a net exporter for both. The European Union however is completely dependent on either Russia or the OPEC oil sheiks, we will be hit real hard (but that shouldn't bother US stocks all too much).
> The last time wheat prices went through the roof in North Africa it kicked off the Arab Spring and subsequent Syrian Civil War as side effects.
That one will be the real interesting part, but again, it's mostly us Europeans who will feel the impact the most - the US can simply send off a bunch of soldiers to the Mexican border and continue treating people fleeing from utter poverty even worse than us Europeans manage to do. The US doesn't care all too much about Africa, Arabia and most of Asia except China and Russia any more, no matter what goes down there they won't involve themselves.
The problem for us Europeans is that our leaders are ineffective and the crises are accumulating:
- the UK government is outright collapsing at the moment and its society fracturing up, not to mention the economic consequences of Brexit or the potential split-offs of Scotland and Northern Ireland. I don't even want to speculate when they will have a stable-ish government with sane policies again.
- France is headed for difficult times, similar to Obama's last six years Macron will have to live without a parliamentary majority
- The Dutch government is still unstable and it's highly unlikely Rutte will survive his term
- Germany... well, Olaf Scholz is no leader, doesn't want to be a leader and frankly he should resign. The coalition itself is beginning to tear apart, particularly because of the financially extremist FDP.
- Europe still doesn't have any sort of common concept on how to deal with immigrants and refugees, partially because Viktor Orban and the Polish PiS keep blocking anything that would require them to house their fair share of migrants or even pay in solidarity. Meanwhile at the borders, horrible crimes against humanity are reported regularly (beatings and illegal pushbacks at the Poland-Belarus border, refugees being extorted by Greek border police to aid in illegal pushbacks at the Turkish sea border, refugees dying at the Spain-Maroccan border in Melilla, people drowning at sea because aid ships are regularly seized by Italian police, ...). The Turkish dictator Erdogan keeps using refugees or the threat of sending them as a political way of extortion.
- Germany has long undermined any sort of independency from Russian gas and oil, and now we're doing dirty deals with Qatar instead of forcefully modernizing industry and housing or doing anything to meaningfully conserve energy.
- Prices in the EU are exploding: rent, energy, food. And our politicians don't have the will or the financial power to assist those in poverty.
Europe is getting fucked hard, the US may escape that same fate if Biden and especially his Democrat Senators get their shit together.
>The Dutch government is still unstable and it's highly unlikely Rutte will survive his term
I'd be incredibly surprised if anything of note changes in the next few years. The population is way too fractured already. The elderly vote to keep what they currently have, the home owners vote to keep things as is, the people vested in assets will vote to keep things as is, not enough young people to vote against the status quo, and no party ever seems to get enough votes to truly have a significant say in the matter. This situation seems to be present in most countries, too.
>Europe still doesn't have any sort of common concept on how to deal with immigrants and refugees
Because actually dealing with this requires rethinking things from the ground up, and rethinking those things requires governments to do the very things they've been postponing for decades now. Taking immigrants in as-is will hurt the middle class first and foremost, which has been the class to bear the brunt of the burden for every other crisis.
That same middle class includes millions of young adults struggling to find a place in life, get things going, facing a job market which continues to get more brutal regardless of a 'sellers market', and continues to face higher prices and a future where the social benefits they were taxed for won't be available to them. Safe to say, that middle class is slowly getting fed up and done with this.
Meanwhile, we continuously have to feel guilty for even considering the 'haves' would have to start sacrificing something for the sake of society, despite the fact not doing so inevitably means the 'have-nots' are sacrificing things anyway. I wish I was kidding when I say I've heard my fair share of 'think of the poor retired landlords retiring by 50 and living off of your rent money', said without sarcasm.
Sure communism would help us and actually work this time. And even if it doesn't at least it accelerates the path to heaven for millions of people. It is historically pretty reliable in this regard.
You have to make a serious leap in logic to go from "stop making the middle class carry the brunt of the burden every time" to "communism is the answer to everything".
We'll see, but those events were dramatically different. I don't think anyone can easily predict what is going to happen right now by looking at those two events.
You know, from having lived through the 80s and several crashes in between I'd say what sucks today isn't the financial/jobs markets or economy but rather the people and how terrible we've become politically divisive. That's what I see.
That 20% market drop from high just seems to be a correction and it was needed because that market high was based on crazy stuff anyway. But that 20% didn't do jack to 99% of the country. We didn't win when it went up, but inversely, we haven't really lost on its way down.
Sure, inflation sucks but if you ask me - stalling our insatiable appetite to consume is probably a good thing.
It’s clear to anyone who looks at a stock chart from 2020-2022 the entire economy was artificially pumped and we’re living through the dump.
I don’t really know what else people expect voting for gerontocrats who have made their names on leveraged buyouts, insider trader, gaming the courts after their businesses commit fraud and the like. Neither “side” of the political spectrum is innocent of such things, including the voters.
Elder Americans are straight up grifters, free loaders with no ability to accept the rest of the world is not a post-WW2 crater. They were able to win big easy, they are the gold star for nothing generation, due to the rest of the world having been obliterated shortly before their birth.
Electing Romneys, Feinsteins, and the rest is lunacy. They have no idea how to do productive work as the world rebuilt itself without them; they all huddled in offices learning how to design models decoupled from reality, convincing themselves of their genius and work ethic as their families expropriated earnings from workers; because of course they’re owed a cut for producing nothing. It just makes perfect sense.
I'm struggling to find something useful in this comment. I'll just pick one point.
> Elder Americans are straight up grifters, free loaders with no ability to accept the rest of the world is not a post-WW2 crater
Compare against younger Americans who are straight up grifters, free-loaders making up crypto coins and NFTs and other garbage that wastes precious natural resources for their scammy activities?
In case my point isn't clear, you're attributing to some class of people an attitude that equally applies to all other classes of people, but in a way that somehow implies it's special to that one.
I guess the one useful tidbit I can get from your comment is... well... it's already a tired cliché, albeit true: neither American political party is the friend of the little people. And although those parties are dominated by Feinsteins and McConnells, there are still Bernie Sanders and Rand Pauls.
So... what do we do about that? Other than discriminate against some class of people that's your personal outgroup?
Maybe work at a local level to elevate more Sanders and Pauls?
Private Equity is an arbitrage on bloated companies. Typical cycle is innovative startup -> efficient corporation -> beauracratic corporation. PE firms buy the companies late in the cycle and then cut the fat. Commonly also seen in activist investors. This is a needed function that will never go away.
It's a bit of a romanticized view. Like a junk yard mechanic opining on the circle of life.
Some PE firms definitely resurrect companies. But a lot are junk yards for companies: they buy to divest & accelerate lifetime profits to today, knowing they'll just dispose the husk at the end. Others are monopoly plays: "roll ups" of local/regional players until there's just one option left and they can raise prices. Still others are growth plays: they're willing/able to take bigger risks, for bigger rewards. And others exist too.
Notably, all would likely describe themselves as arbitrage on bloated/mismanaged companies.
A lot of people view companies as fundamental and bankruptcy as bad because companies are the biggest "things" you can point to in the economy. But the economy itself doesn't think in those terms (it doesn't really think in any terms, not being alive). The fundamental assets in the economy are land, labor, capital, and information, and a firm is just a way to organize those factors of production to do something useful. Over time the optimal way to do things often shifts so that whole companies become obsolete, but the incentive of everyone involved in a company is to make sure the company keeps existing.
The role of a P/E firm or corporate raider is to buy the company, strip all the assets off, sell them to other companies that will use them more efficiently, lay off all the employees, and force them to get other jobs. Which sounds utterly cruel if you think of the company itself as a thing whose existence you want to preserve, but if you think of the company as an organization of convenience which should be dismantled and reconfigured when economic & technological conditions change, you are just paving the way for other companies to flourish.
My only quibble is how you frame "optimality" as an objective parameter, shifting with the tides of time.
Monopolies are usually optimal for the owner. Similarly, PE rollups are optimal for the owners. You're right, of course, that when you value a company in terms of "fundamental assets" then PE strategies make total sense.
But if these companies are simply organizations of assets, then why create them? The general purpose of companies is production: to make a profit, yes, but also to provide a value surplus to customers.
People dislike PE not because they're cruel, but because people get that they "optimize" for owner profit over customer surplus.
A necessary tool? Certainly, it often is. But optimal use is important too. With a cost of capital near 0 ... why wouldn't the tool be overused, destroying economic value it was meant to create?
In the presence of competition "optimal for owner" equates to "optimal for the system at large", because competition between PE firms will bid up the price they pay for the initial company until it's fair, it'll bid down the interest rate the bank charges, it ensures that the assets actually go to the firm best able to make use of them, it provides landing positions for the employees who are let go and then can get the best salary possible, etc.
In the absence of competition misallocation can occur, and that's why it's the governments job to stomp out monopolies. (Something that they've been sucking at, but if you want to argue for better anti-monopoly enforcement I'm all for it.)
There's wide-ranging literature on why companies exist [1], but it's not for production. Individual laborers independently contracting with each other can produce value, and do so without the monopoly risks mentioned in the last paragraph. Usually theories of the firm center around transaction costs: it takes money to identify, review, trust, and collect payment from other firms you do business with, and so you can improve efficiency (up to a point) by centralizing all the producers in one firm under a management hierarchy that doesn't pay them directly but is tasked with optimizing output. Other theories of the firm have shown that management doesn't actually optimize output and (surprise surprise) optimizes for their own status, promotions, and other human motivations instead, but as long as the deadweight loss from them being self-interested is less than the search costs of contracting with another company, it's economically rational. P/E operates essentially by taking on that search cost of dismantling the company and selling it on the open market, and pockets the difference between the deadweight loss of manager principal-agent problems and those search costs.
Cost of capital being 0 is a separate issue. The effect of this is to make any investment with positive returns a good one, regardless of how good it is, which creates a lot of bloat and misguided investments in companies. It's essentially making the economy a target-rich environment for P/E.
> In the presence of competition "optimal for owner" equates to "optimal for the system at large"
I'd humbly suggest that the system is comprised of more than mere owners.
> There's wide-ranging literature on why companies exist [1]
Indeed. Are you suggesting they describe examples of firms that don't produce, and never intends to do so? I'd be very interested to learn about them, as I'm surprised to hear someone imply The Theory of the Firm describes organizations without output.
Let’s be honest here, PE firms exist to make partners rich, not to reallocate misused capital and force people to get a productive job. Their mechanisms are described by the OP and may sometimes result in those things but those are not the goal or the motivation.
Bankruptcies are a necessary evil but they are always awful, traumatic experiences for employees, and often PE will force reorgs, acquisitions and layoffs not because they are best for the economy or employees but because they are best for the new owners.
I was thinking something like this yesterday when someone posted a blog post about an evolutionary perspective on product market fit. That ended up being a bit of a misnomer and it was really an article about the observation that sex sells, and people are motivated by sex because of evolution, but I was thinking what the article should have been is the real evolutionary perspective is competition itself. Nobody other than you as a founder gives a shit if your specific company succeeds. All that matters is that a need is addressed, some product fits some market. As a consumer, I don't give a crap who is at the other end of a transaction profiting just so long as I get the product I need. As an investor, thanks to diversification, I don't really give a shit which companies make it and which don't just so long as an entire sector grows. Even as an employee in an industry where it is very easy and quick to find a new job and it usually involves a pay raise, I'm not sure I care all that much if my employer continues to exist. I'm not even really sure you should care that much as a founder. As long as funding sources continue to give you money and you use some of that to pay yourself, if one idea fails, try another. Don't get too attached to whatever you're working on right this minute, just so long as at least one thing you try eventually works.
Think of like the commercial equivalent of the United States and every constitutional republic that has followed. We don't have kings. Institutions should outlive regimes. Dynamic markets are healthy markets. Chaos is a ladder or something like that.
There's another type of PE out there beyond what you've described which is, the owner of a moderately sized privately owned firm (doing somewhere between 10-100 mil revenue a year) wants to retire and sell it off, and PE firms are the only ones who can afford to buy it for the 100mil+ price tag it warrants.
Typically they cut a bunch of expensive overhead, like employees, which juices the books to make it look much more profitable, then sell to someone else left holding the bag of a dead shell of a company. Cut long term viability for short term gains.
I think it’s fair to assume both exist. The (small) company I work for sold to PE in 2019. They basically dumped a bunch of money in to help us scale up quickly. It hasn’t all been great, but revenue continues to grow and we have (many) more employees than before from top to bottom. I expect they’ll probably try and move on soon to realize their gains, but the next buyer definitely won’t be receiving a “dead shell” unless they somehow fail to retain the employees during the transition.
We got juiced by PE. Hiring went to absolute shit. Nobody knows whos in charge anymore. Decision makers have all left the company. I just make everything up as I go along and people go with it because I've been around so long nobody will question it.
Sometimes squeezing the last drops of juice out of a doomed lemon is the economically most efficient thing to do. The purpose of a company is to serve the interests of its shareholders (within the bounds of law), not to survive indefinitely. We all know cases of companies that squandered value in vain attempts to stay alive, when they just could have slowly put themselves out of business and returned the last years of profits to their shareholders. Kodak, I'm looking at you.
On the flip side, losing money is a known risk of investing. Can't afford suboptimal returns because the C-suite tried to build a legacy by resurrecting the company? You had no business investing in the first place.
The owners? The customers? The employees? The country? Competitors? My 401K? The creditors?
Some of these stakeholders net-win when zombies die, and some of them net-lose. The economy isn't a zero-sum game, but particular categories of actions in it can produce net-negative outcomes for one of these groups. You can't just wave a large brush and say that everyone net-wins when this happens. It's a case-by-case thing.
Eddie Lampert's corporate plundering of Sears is an example of just about everyone but him (Maybe including him? It's hard to tell) losing.
It's likely to be positive for all of those, even the employees. Who gains from the destruction of value?
> stakeholders
I hate this term. It's a deliberate attempt to blur the boundaries of who owns something and who does not. It's not shoplifting if I'm a stakeholder in this pack of cigarettes, right?
Our society isn't, and shouldn't solely be structured around prioritising the comfort of the people who own it above all others, despite how much they wish that it would.
One view does not exclude the other. Predators have a role in ecosystems, culling the weak and the sick from the herd. PEs are corporate predators, preying on bloated orgs, killing them, returning whatever value still held (trademarks, patents) back to the "environment".
But of course that "pure market" viewpoint doesn't take into account the social costs and individual pains these operations entail.
Apart from they wreck perfectly viable businesses…
Let’s take Debenhams in the UK as an example
- Used to own all it’s stores
- Got bought by PE (who attached the debt they used to buy Debenhams to Debenhams so the PE group now owe zero)
- Split the stores from the retail operation but made the retail operation lease them on ever increasing rents
- Sold the stores to British Land
- Eventually Debenhams retail can’t afford the rents (as they only ever increase), and the debt payments so goes bust
Similar patterns with PE acquired companies not being able to afford their debt payments is common, coupled with PE companies extracting any free cash as a dividend shortly after purchase
What PE companies are doing isn’t culling the weak but extracting the most they can from businesses and then leaving suppliers, employees, pension scheme members to pick up the cost
That's not what he's talking about. Ruthlessness has its role in a robust ecosystem, but screwing with a company in a way that destroys its viability simply to trick some retail investors and pension funds into buying the worthless shell is not part of a robust ecosystem.
In a libertarian world, you're right. But in the USA today, those "stupid investors" are often pension funds who will just tax you more when they lose it all.
unironically, yes. in an ideal capitalist system, money should flow to those who can best allocate it, so stupid investors losing $$$ to more savvy investors in financial pvp is the market working as intended.
I've seen both. A place I worked once got bought by PE, and they cut development costs for a product which was becoming less and less relevant anyways. There's a variety of opinions about that.
You look at Toys R Us, and a few other major retailers, it is as you say.
Even the successful PE stories get bad press - as they often involve painful restructuring. But the big failures do get much more coverage for obvious reasons.
If this were commonly true, who are the dumbasses buying companies from private equity funds, and why would they continue to buy them? And, whether your statement is true or not, why should I (or anyone else) feel bad for anyone who would buy back a company that has been gutted and has no future? This is business, people are supposed to be professional and to differentiate opportunity from disaster.
Lastly, "Cutting long term viability for short term gains." actually sounds somewhat noble. Why should a company exist for 50 years when all of its usefulness (i.e. profit) can be extracted in 5? Let everyone move on to something else productive. If you owned an oil well you could exhaust in 5 years, you'd do it, not sip at it for the next 50.
Since people hate PE funds so much (after all, they are usually led by billionaires), why is there so much despair over one PE fund selling another PE fund a lump of garbage? I'd think many people would celebrate.
> Typically they cut a bunch of expensive overhead, like employees, which juices the books to make it look much more profitable, then sell to someone else left holding the bag of a dead shell of a company. Cut long term viability for short term gains.
This really only exists in large cap deals. Most middle market deals are actually about long term viability...mainly because they have to sell to other PEs or strategics that will underwrite the long term viability during diligence when they go to buy. Large cap on the other hand will typically try to IPO it where the public investor might be left holding the bag (or creditors, or employees).
The goal of PE firms is to exit their investments. Do you think PE is a long running greater fool scam, where there’s always a foolish buyer available.
Or, do you think sometimes the buyers are not getting a dead shell?
Wild that what's obvious to ransom HN commenters hasn't been noticed by the guys buying the dead shells of companies. You'd think that it would be important to them.
Or maybe that's anecdotal and not necessarily the brought trend.
>Wild that what's obvious to ransom HN commenters hasn't been noticed by the guys buying the dead shells of companies.
It isn't so wild when you consider cases like Sears, where Eddie Lampert in effect used a variety of shell companies to sell off the profitable parts to himself.
Theoretically, yes; in practice most private equity is no better at management than the people they are replacing. Often times they miss the fat and cut the bone instead.
It's hard to actually see what provides company value and what is actually expendable. Remember that the whole idea behind free markets is that you can't perfectly know and precalculate every input and output of an economy; you want a distributed set of economic actors making decisions for themselves. And large businesses are not immune to this - they operate not like tribes, but like little mini-economies unto themselves. If we actually could "cut the fat", command economies would have worked and America would have collapsed instead of the Soviet Union.
People take over organizations and loot them for personal gain. It's the simplest business model imaginable.
In fairness that's not the only PE model. The other model is to buy up competing businesses, engage in anti-competitive practices, and extract monopoly rents from a sector.
In my view, someone from the uk, they generally buy companies and strip as much money as they can out of the company by selling bits off or they buy it and load it up with debt and then take as much money as they can out.
If by fall you mean from its all time highs, sure, but theres still so much money allocated that needs to be spent:
After 10 years of steady growth, dry powder set yet another record in 2021, rising to $3.4 trillion globally, with approximately $1 trillion of that sitting in buyout funds and getting older (see Figures 8 and 9).[0]
There was an all time high of 490 buyout funds closed in 2021. What is very likely is that many of these new funds (I see a lot of them...the 8-man shops that came from MDs at places like KKR, Carlyle, Apollo, etc.) will just fizzle out.
Like everything else, it's just gettting corrected.
Speaking as someone who came from PE, agree that higher rate environment means both better investment alternatives and also more expensive capital for LBOs. That said, the firms with fresh capital can make a ton of money buying into this environment. Zendesk being a great first example. Not a huge amount of debt required to do these types of deals. Liquidity going to hide under the figurative rock of fixed income means values get dragged down, which creates an incredible buying opportunity for all these PE funds. Look 5-7 years out, I'd guess 2022 and 2023 vintage funds will be some of the best in history.
This article is little more than a signal to the PE industry to sink their claws deeper into the regulatory apparatuses of the US government. And they'll do it, because we have a very ineffective regulatory system.
Somewhat interesting perspective on PE in this Bloomberg podcast, which does a reasonable job of explaining why ~23:30
1. PE has had an easy run - rising interest rates and rising value of equity
2. Guest finds shocking - Given 1, PE returns net of fees and adjusted for leverage have become very pedestrian relative to S&P500. If the IPO market slows due to interest rates, then this may trap PE institutional investors.
On the other hand inflationary environments are great for infrastructure and Real Estate investments.
If one type of private equity might be headed for a fall (nobody has the crystal ball) PERE (Private Equity Real Estate) and PEInfra (Private Equity Infrastructure) might benefit from it.
Why would you manage real estate with a shitty cap rate, when you can buy bonds that have less overhead, risk and more liquidity? Real estate funds are a great idea when rents are going up, but it isn't so clear that will keep happening. Or appreciation is expected. That's definitely not happening anymore.
Pension funds, insurance companies and SWFs don't reason like individuals, they have to put their money to work and for them the vast majority is govt. bonds anyway, even in the past 10 years.
By the same token they have to decide what to do with the 15-20% which isn't bonds. Just as a matter of portfolio construction you don't want to be in equities, don't want to be in Venture. Only Real Estate and Infrastructure are left
Real Estate benefits from cheap money, which dries up in an inflationary environment as central bank juice rates. We're already seeing sizable jumps forecasted for the remainder of 2022 and beyond as this inflationary spiral finally takes off.
People will always gamble when its other peoples money. And for those who did not find true inflationary shelters to soften the impact, things are going to get worse before they improve.
Admittedly, I too was stuck with some laggard energy ETFs for years thanks to being naive enough to listen to a banker once (tax event trap), and even that garbage has bounced back like a dead cat (I have to donate to VOKRA every-time I repeat that colloquialism).
I am not bullish on dirt backed holdings these days. While it is easy to fall into a FOMO mindset in a manipulated market.. eventually the gamblers left at the table always lose. Annual sales are down 43%, record prices pumped another 5%, but inflation is up 7.5% and growing. i.e. you may yet end up one of the lucky ones if you time things right. ;-)
There is a structural element to consider since PE has raised huge amounts of dry powder and will continue to do so....which means there is huge demand from committed capital that has to be invested...not sure it will go away any time soon since the dry powder will help support valuations to a certain extent even if they come down with higher interest rates.
Make sure you don't have an ARM. ARM holders might see their payments skyrocket when it goes off the fixed rate.
If you currently have a fixed rate mortgage then you are locked in and in great shape. Nothing will change monthly in your mortgage. The "what does this mean" could be that you can comfortably afford to live there but that moving would become much more expensive that you are stuck in your current home for five years.
I don't know what that would mean. You sell your house as a owner-financed thing? It still doesn't get you the cash up front to put down on a new house.
ARMs sold today are typically it the 5/1,7/1,10/1 variety. The terms outline the maximum increase per year and lifetime after the fix ends. A doubling or tripling of payment immediately at the end of the fix term would be unusual.
