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Welcome to a new, low-key private equity industry

Manexecuting the past For a decade, it sometimes seemed like anyone could be a private equity investor. Rising valuations at portfolio companies, and cheap financing to buy them, have boosted returns and generated cash at breakneck speed. In contrast, improving the efficiency of portfolio companies contributed much less to industry returns. As acquisitions accelerated, more and more Americans were employed indirectly by the industry; today, more than 10 million employees work for its portfolio companies. But last year, as valuations fell and leverage became scarce, the twin tailwinds for private equity reversed. By the summer, the deal had collapsed. Deals struck at high prices during the boom years are starting to look a little reckless.

Private equity is entering a new era. After months of inaction, deal makers are getting back to work. Economic uncertainty is still weighing on buyers and sellers’ expectations, but more major deals were announced in March than in any month since last May. In one such deal, tech investor Silver Lake announced it would buy software company Qualtrics for more than $12 billion, with a commitment to take on $1 billion in debt—an acquisition that, while not highly leveraged, was nonetheless an acquisition. The industry that emerges during this period will not be the same as the omnipotent giants of the 2010s. Private equity will be plagued by its folly at the top of the cycle. The growth rate of assets may slow down. The new phase will benefit investors willing to roll up their sleeves to improve the operations of acquired companies.

Because funds that invest in a downturn are often among the most profitable in private equity, some managers realize that recession expectations have created bargains and are now eager to deploy capital. They are buying companies whose valuations have been hit by rising interest rates. On April 17, The Hut Group announced that it had received a non-binding offer from private equity giant Apollo. Shares in the struggling British e-commerce company have fallen 90% since 2021. In February, Francisco Partners beat out potential private equity buyers to buy Sumo Logic for $1.7 billion, or about four times its annual sales. The US software company trades at more than 15 times 2021 earnings. Another private-equity giant, Bain Capital, set up a $2.4bn tech fund to capitalize on the industry’s turmoil.

The company spin-off also has people in vests excited. Such deals, in which large companies shed unpopular assets, have taken a smaller share of private equity deals since the 2007-09 global financial crisis. But given tough economic conditions, companies are increasingly looking to sell “non-core” assets to focus operations and strengthen balance sheets. Announced spin-offs from U.S. companies will surge by about a third in 2022, according to bank Goldman Sachs.

The problem is that today’s bargains are yesterday’s rip-offs – transactions were much faster a few years ago. Buying at market tops is a disaster, whether that market is public or private. One staunch private-equity boss says he likes to remind his investors that anyone who bought Microsoft stock in the months leading up to the dot-com bust in 2000 had to wait until 2015 to break even. This score is retained by quarterly valuations until the investment is sold. Investors in private equity funds do not expect to see significant writedowns on their investments. But of the $1.1 trillion spent on acquisitions in 2021, it was the third investment in technology companies, often at the highest valuations, that has attracted the most attention.

Older deals pose a particular threat to funds that are more prone to triggers. The cost of floating-rate borrowing has soared.Morningstar Yield ista The leveraged loan index jumped to 9.4% from 4.6% a year ago. While recent acquisitions have involved less borrowing as a share of their value, the high valuation still means borrowing has increased relative to profits. This has some companies walking a tightrope financially.

High interest costs can be toxic when mixed with the underlying business problems of a portfolio company. Consider the British supermarket Morrisons bought by US investors Clayton, Dubilier and Rice. The grocer has lost market share to cheaper retailers as inflation strains customers’ wallets. The company’s interest bill will more than quadruple this year, according to research firm CreditSights. Things can be even more dangerous in the tech sector, where many of the biggest deals of the past few years have been financed with floating-rate loans.

As with any down market, many funds will struggle to raise capital. A more existential question is whether the opportunities now available can sustain an industry that has grown. Andrea Auerbach of investment firm Cambridge Associates said she was “most concerned about returns being contested at the top end of the market, where there are fewer managers and more dry powder”.

Because of the growing size of the industry, mega-funds raising more than $5 billion are now more common than in the past. In the US, such funds are sitting on about $340 billion in dry powder, an amount that could double if leverage is used. Optimists point to the size of the public market as a comparison. There are about 1,100 profitable public companies in the US with market capitalizations between $1 billion and $20 billion; their combined market capitalization is about $6 trillion. While that might seem like a huge pile of potential targets, an investment committee looking for the quality of Goldilocks’ operations might find that it’s not exactly big enough.

In this more restrained era, private equity managers may have to abandon their habit of chasing the same goals. About 40% of portfolio company sales over the past decade have been to another private equity fund. But fewer operational improvements may have been made to these companies, making them less attractive to buyers.

Private equity managers who cannot acquire cheaply need to increase the profitability of their assets if they want to make money. They can be efficient custodians; concentrated ownership, propensity to bring in outside managers with financial incentives to improve margins, tight cost controls, and side deals (where a fund merges another smaller business into its portfolio company) All help to increase profits. For many companies, however, such operational improvements have been a side event over the past decade — rising valuations relative to profits account for more than half of private equity returns, according to an analysis by consultancy Bain & Company. Between 2017 and 2022, margin improvements provide a meager 5% return.

Don’t expect the shift from finance to operations engineering to benefit all private equity funds equally, even if refurbishing old textbooks will improve the industry’s stewardship. Higher debt costs make add-ons more expensive, and such deals are increasingly in the spotlight of wary competition authorities. The downturn could also intensify political opposition to cost-cutting in the industry, especially in sensitive sectors such as health care.

All of this means that pension funds and endowments, the typical investors in private equity, will spend the next few years debating which managers are actually earning their hefty fees. Most of the corporate raiders—veterans of the leveraged finance explosion of the 1980s—are long retired. In its place is a group of professional money makers too young to recall the prehistoric high rates of their industry. Those who can bargain, and managers with deep industry expertise and a pool of skilled operating professionals, are likely to prosper. Bidders, buoyed by rising valuations and low leverage over the past decade, certainly won’t.

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