When Wall Street money managers fall from grace, there’s usually some kind of discernible ruckus: the wail of angry investors, the steady drone of thousands of lawyers filing cases, and the rush of doomer headlines in the financial press. But even as some of Wall Street’s elite are getting decimated, you can barely hear a sound.
In the post-financial-crisis world of zero interest rates, private equity — a clubby world of investment firms that use leverage (as well as some equity) to purchase portfolio companies — was one of the few places on Wall Street that guaranteed investors yield. But after that decade of winning, the industry’s fortunes have started to turn — though you probably won’t hear too much about it.
Part of the relative silence is because of the nature of private equity itself. Client funds are locked in, investments are rather hush-hush, and standard fee structures ensure that the rich stay rich regardless of how markets move. Under that blanket of protection, though, you might hear some muffled screams.
In recent years, both the market and American society have turned on private equity. Rising interest rates have thrown a wrench in PE’s debt-laden business model. Meanwhile, regulators are starting to view PE’s practices as anticompetitive and antisocial. In a post-COVID, pro-reshoring world, PE’s ethos of efficiency is giving way to a reclamation of the redundant — a recognition that even if it’s more expensive, having extra capacity in the economy benefits competition, public health, and national security.
Look, I’m not saying that the private-equity section of the billionaire boys’ club is about to empty out — I’m saying it’s going to be a few messy years. We’re going to see companies blow up, we’re going to see balance sheets get strained, and in that chaos, we’re going to see a whole bunch of money get flushed down the drain.
Even the biggest and best
PE has made it rain for so long because its most common playbook is based on debt. First, a private-equity firm raises money for a fund using some of its own capital and some from outside investors. Second, the firm finds a business they think is underperforming or in a weak position and gobbles it up. But! Instead of blowing through all of the fund’s cash upfront, the PE firm uses a sliver of that cash to invest in the firm and takes out a loan on the company’s behalf to cover the rest. Then the investors dump all of that debt onto the company’s balance sheet, a move called a leveraged buyout. After that, the firm gets to work trying to strengthen the company, maybe through layoffs or maybe by making internal processes more efficient. Once the company is “right-sized” and making enough to start paying off the debt, the PE firm flips the company, either by taking it back to the public markets via an IPO or selling it to another party — a competitor, a conglomerate, what have you.
The years following the financial crisis were perfect for this kind of play. Because interest rates around the world were at zero, it was easy to take out a loan and cheap to manage all that debt. Investors, meanwhile, especially the large institutional ones like pension funds, had limited options for fat returns in a world where once-safe bonds yielded so little. So they were willing to dive headfirst into anything that promised them higher-than-average returns. By 2022, the American Investment Council reported that more than one-in-10 US pension funds were invested in private equity. Back in 2006, alternative investments — money put toward private equity, hedge funds, and distressed real-estate debt — made up just 11% of public pension fund’s portfolios, by 2016 that number had hit 26%. By 2021, the last year of the golden times, PE did a record $1.2 trillion worth of deals, according to PitchBook.
When the Federal Reserve started hiking interest rates, fortunes changed in kind. Taking out a loan has become more expensive, drastically changing the rationality of private equity’s business model. Leveraged buyouts suddenly look stupid, and PE dealmaking drastically decelerated to where it sits now, at a four-year low and well below pre-pandemic levels. Along with fewer deals, PE firms have also been forced to hold on to (potentially) debt-laden companies for longer. The average holding period for US and Canadian buyout companies has risen to 7.3 years in 2023, the longest hold time since 2000, according to S&P Global Market Intelligence. Other signs of this pain are everywhere: The number of new PE funds being launched has fallen off a cliff, and making matters worse for PE, bonds are back, baby. For investors, why give all your millions to private-equity firms to take on risk when safe, investment-grade bonds are yielding mid-single digits?
Even the biggest players have various reasons to worry. Over at Carlyle Group, distributable earnings — profits that can be returned to shareholders — fell to $367.4 million in the third quarter, down 43% from the same time last year. At KKR, distributable earnings in the third quarter were down 6.6% compared to the same time the year before, much better than the 23% year-on-year drop the firm reported in the second quarter. This summer, the ratings agency Moody’s downgraded Blackstone, Apollo, and KKR because of their large commercial real-estate holdings (only 66% of US workers have returned to the office full time, most reports indicate).
“Now we are at a point in time when PE is starting to lose the differential, the alpha, where they are making more money than other investments,” the Pulitzer Prize-winning journalist Gretchen Morgenson said in a recent interview about her book, “These Are the Plunderers: How Private Equity Runs ― and Wrecks ― America.”
Private-equity firms were able to hide these troubles for a while, thanks in large part to the way they structure their investment vehicles. Morgenson and her coauthor, Joshua Rosner, argue that PE’s proprietary way of marking the value of their investments has been — at least on paper — providing the industry with exaggerated returns compared to public companies. Publicly traded companies must disclose financial information, but PE acquisitions are privately held. That opacity has given PE an opportunity for what Morgenson called “wiggle room … if not outright lying about what the performance numbers are.”
There is no denying that in the face of higher interest rates, some in the industry are engaging in a bit of sleight of hand. Reporters at the Financial Times put together an excellent rundown of the kind of financial contortions money managers are using these days: holding on to good assets and moving them into funds with poorly performing assets; deferring interest payments for debt-laden companies and instead adding them to the overall debt pile to be paid at some later date; collateralizing good assets to pay off debt for failing ones. Obviously, none of these are permanent solutions.
The more time passes, the more money PE firms need to spend to hold their portfolio companies, and the harder it gets to juggle all this. Conditions will improve for private equity when interest rates go down. Until then, and perhaps even after that, expect the internal asset churn to continue until some firms quietly shutter or turn into zombie firms, sucking up fees to hold on to stagnating companies while too-patient investors get stuck holding the bag.
From go-go to get out
For decades, private-equity firms have made it their mission to right-size US corporations: compelling companies that investment managers deem “underperforming” to lay off workers, sell assets, and slash costs, even if it meant a worse product for the end consumer. So it’s somewhat ironic that US policymakers are starting to wonder if it’s the PE industry that needs to be right-sized. It was one thing when PE was seeking to squeeze out efficiencies from bloated industrial conglomerates or moribund IT firms, but over the past decade-plus, the tentacles of private equity have spread to a wider range of industries — from HVAC repair and higher education to nursing homes and hospitals. It’s become clear that the efficiency-obsessed tactics are hurting consumers and leaving our most vulnerable members of society in the lurch.
Let’s take higher education, for example. It’s an industry heavily dependent on government subsidies, and private-equity firms have been able to acquire hundreds of for-profit schools and capture those subsidies for their investors. The problem, according to a 2018 paper by researchers at NYU’s Stern School of Business, is that the students get shortchanged out of a quality education.
In a study of 88 private-equity deals and 994 schools under PE ownership, the researchers concluded that “private equity buyouts lead to higher enrollment and profits, but also to lower education inputs, higher tuition, higher per-student debt, lower graduation rates, lower student loan repayment rates, and lower earnings among graduates.”
It’s the same story at nursing homes. A study by the National Bureau of Economic Research found that PE-owned nursing homes are more likely to be understaffed, pay higher management fees, charge patients more, and have higher patient-mortality rates. “Patients admitted to private equity-owned nursing homes are 50% more likely to be placed on antipsychotic medication. By sedating patients rather than applying behavioral therapy, nursing homes can reduce staffing needs. Private equity-owned homes also perform below average in two other key metrics of well-being: patients experience a greater decline in mobility and increased levels of pain,” the paper said.
In 2022, Congress passed the No Surprises Act, to stop hospitals from charging patients unexpected, eye-popping bills after visits to the emergency room. Private-equity-owned hospitals were the driving force behind those surprise charges, and they fought as hard as they could to keep the bill from passing. Researchers estimate that 25% to 40% of emergency rooms are run by PE firms.
“One of the trends we’ve seen over the last decade is greater expansion of PE in healthcare markets,” Lina Khan, the Federal Trade Commission chair, said on a recent episode of the Bloomberg podcast “Odd Lots.” “At the FTC, we are business-model agnostic, but we have been hearing from a whole lot of market participants, including healthcare workers, about the ways in which PE’s incursion can result in detrimental outcomes.”
One practice Khan is specifically concerned about is called a roll-up — in which a PE firm buys up all the small businesses in an area that are focused on the same type of service and merges them. In theory, this sort of consolidation is supposed to make operations more efficient by combining resources to lower costs — not to mention net the investors a tidy profit. But in reality, it creates a monopoly that is able to control prices. The FTC recently brought a lawsuit against a Texas-based company, US Anesthesia Partners, and the private-equity firm Welsh, Carson, Anderson & Stowe, accusing them of a scheme to buy up all of Texas’ largest anesthesiology practices in order to jack up prices. “This action puts the market on notice that we will scrutinize roll-up schemes,” Khan said.
Lina Khan, Federal Trade Commission chair
No, this isn’t to say that all PE firms are out to do evil, but their business model has clear limits. If the pandemic taught us anything, it is that efficiency isn’t everything, nor should it be in all cases. When it comes to certain sectors of the economy, it’s in the public interest to allow humanity to supersede the numbers.
I wish I could tell you that someone, somewhere was working on changing the private-equity game so that risk is more equitably distributed throughout the process. There are some in Washington, like Sen. Elizabeth Warren, who want to pass legislation that would force PE companies to wait two years before using the debt on acquisition companies to pay out dividends to investors. And of course, Democrats and some Republicans have agreed for years that it’s time to close the carried-interest loophole — a rule that allows investment-fund gains to be taxed at a lower rate and largely benefits PE firms and hedge funds. And yet, it somehow never gets done. Both of these practices help keep the industry humming along, even as investments fail. That is why all of this money is dissipating so soundlessly.
When a private-equity firm invests in a business, it often streamlines operations down to the last penny. But if the past decade or so has shown us anything about the industry, it’s how to succeed with excess — an excess of capital, an excess of leverage, and an excess of opportunities. We’re about to find out if the industry can survive without it, or if it was really excess keeping the kings of efficiency fat and happy all along.
Linette Lopez is a senior correspondent at Business Insider.
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