The recent collapse of Monarch Airlines and the potential surrender of care home group Four Seasons to creditors may well be a sign of the times for the private equity industry. The sector is known for turning round companies, slashing costs, increasing cash flow and using debt to reduce tax and mitigate risk, but the model is now looking fragile.
Private equity (PE) was in its pomp in the 1980s, and in 1990, Richard Gere provided a useful cultural reference point with his portrayal of a (temporarily) ruthless private equity partner in the blockbuster film Pretty Woman. But now, an oversupply of rival funds and investor money looking for opportunities is forcing investment in higher-risk business and the acceptance of more marginal returns. The sector buys major stakes in companies that are not publicly listed, but bigger acquisitions are costing too much partly thanks to high stock market valuations.
Just as it was for acquisitive conglomerates such as Hanson Trust that were the precursor to the PE industry, it may well be that the model has run its course and is ready to be replaced by something else. And that will affect more than just the managers. Pension funds have been steadily building allocations to private equity over recent years. As of 2016, the average US public pension had 7% of its assets invested in the sector.
Some would argue that this is more about recent strong index performance than underperforming private equity. However, private equity funds tend to operate over a ten-year cycle, declaring returns only when they close and pay out. That means performance is heavily lagged – in other words, numbers we look at now reflect trends over the previous decade, not current performance. Current performance is likely to have deteriorated still further.
One clear trend in the industry is that significant numbers of partners are leaving the major PE players and setting up their own funds. Some may have been pushed due to mediocre investment performance, but others are leaving to raise their own funds and compete with their former employer.
Increased competition is lowering returns for all and the outlook is sustained pressure on profits. In many ways, it is simply too easy for those with skills in the industry to raise cash. PE is awash with money as old funds mature and returning funds look for a home. There is no shortage of available funds to invest in and borrowing is cheap and readily available.
And it’s no surprise that eyes might turn to PE. The industry has historically outperformed share indices and to some extent investors do tend to base current investment decisions on past performance.
All of this means that the PE industry now has plenty of funds; in 2015 US$185 billion was raised by PE in the US alone, an all-time high. However there is a paucity of opportunities. Bidding on potential targets, most commonly mature businesses which are sold off by corporates as non-core operations, is ferociously competitive. The result is higher prices, which serve to reduce the likely returns further down the line.
The longevity of the private equity industry brings its own problems. Attractive opportunities have declined as many businesses have already been through PE at some stage. The potential benefits from a secondary PE owner are bound to be less.
Such companies will already have been subject to financial engineering with assets fully leveraged, and costs honed to the point of limiting future growth. Multinationals disposing of business categorised as no longer core have become more aware of the true value in the market. In short, targets are no longer selling at bargain values which characterised many previous disposals.
And when it goes wrong, the business model for private equity looks shaky. PE firms have always been adept at laying off much of the downside risk to others while ensuring their investors fully benefit from upside potential. That’s why firms under private equity control tend to load up on bank debt, and secure protection through warranties and indemnities from the business sellers and incumbent managers, and through insurance policies for many eventualities. In turn, PE will not provide warranties for the business when sold, beyond a few basic essentials.
Look at the recent demise of Monarch, the biggest ever UK airline collapse. Investors in Greybull Capital – the private equity firm which held a majority investment in Monarch – may recoup their £250m investment. However, other parties to the airline, such as banks and creditors, carry the losses. Meanwhile the government picks up the substantial costs of repatriating marooned passengers.
Guy Hands’ PE house Terra Firma bought EMI the recording house for £4.2 billion in 2007 and after a dismal performance the banks were left with remnants valued at around £1 billion. More recently, Terra Firma has just dumped nursing home business Four Seasons on its creditors after losses of £450m. Terra Firma, as many PE firms are, is currently attempting raise a £3 billion fund.
The lesson here is that the market is getting tough. We should expect more bankruptcies as PE is forced into increasingly risky bets. Banks will no doubt be increasing the risk premium on borrowings to PE-owned business, and will reduce lending in view of increasing risks, which will load more pressure on PE returns before it dampens activity in the industry.
Private equity is traditionally viewed as an attractive destination for money with a ten-year time horizon. However the outlook right now is far less attractive. A major increase in competition and a shortage of opportunities suggest that the genre has more than reached maturity and decline is now the outlook. If investors want to look for the next big growth market, they could do worse than look to activist investors to shake up sleepy and self-serving boards of which there is no great shortage.