Private equity has surged in popularity over the past decade thanks to ever-larger allocations from wealthy individuals, families, pension funds, endowments and institutions. The outbreak of the novel coronavirus epidemic (Covid-19) has thrown many private equity firms into turmoil. Thousands of private equity portfolio companies, representing trillions of dollars in investment value, have been idled along with most of the rest of the economy. Like many other small and medium-sized businesses, many of these portfolio companies are hoping for government relief. The PE industry is lobbying hard for a bailout. Given the sheer size to which it has grown, it is hard to see how the federal government can fail to oblige.
Winner of the last financial crisis
The growth in private equity’s popularity since the end of the Great Recession cannot be denied. Indeed, as Bloomberg observed last October, it was the big winner of the financial crisis:
“Private equity managers won the financial crisis. A decade since the world economy almost came apart, big banks are more heavily regulated and scrutinized. Hedge funds, which live on the volatility central banks have worked so hard to quash, have mostly lost their flair. But the firms once known as leveraged buyout shops are thriving. Almost everything that’s happened since 2008 has tilted in their favor. Low interest rates to finance deals? Check. A friendly political climate? Check. A long line of clients? Check.”
According to Preqin, private equity fundraising topped $500 billion every year from 2016 through 2019. Total assets under management reached an all-time high in 2019, with PE funds controlling $4.1 trillion at the turn of the decade. Their dry powder has doubled over the past five years, now standing at about $1.4 trillion.
A questionable appetite for alternatives
The market’s appetite for alternative investments has proven to be nigh insatiable. Major public pensions funds, sovereign wealth funds and endowments have been major allocators to private equity over the past decade, as have high-net worth individuals and families. These vast pools of capital were forced into a multiyear hunt for yield in the face of the veritable “bull market in everything” that followed the financial crisis. This has led to vast allocations in hopes that private equity can deliver superior returns. Unfortunately, these expectations have not always played out in practice.
The April edition of the Journal of Portfolio Management published a scathing review of the performance of alternative investments by Richard M. Ennis, a pioneer of quant investing and institutional investment consulting. Ennis found that, in the context of institutional investors, pension funds and educational endowments, alternative investments have failed to offer significant diversification, as well as the promised market-beating returns:
“Public-market pricing is a much bigger factor in alternative asset markets now than in the past. Alts have ceased to be the diversifiers they once were and have become a significant drag on institutional fund performance. The cost of institutional investing is 1.0% to 1.7% of asset value annually. Public pension funds underperformed passive investment by approximately 1.0% a year for the 10 years ended June 30, 2018; the shortfall of educational endowments was 1.6% a year.”
Endangered by the new crisis
With allocators already starting to question private equity’s high fees and questionable performance, the outbreak of the Covid-19 virus could hardly have happened at a worse time for the industry. Yet, it appears that private equity may be a beneficiary of federal largesse, as the government has made hundreds of billions of dollars to support businesses through the crisis. Unsurprisingly, the industry has been lobbying hard for a piece of this cash.
While some commentators and analysts may balk at the idea of some of the richest companies in the world, such as KKR & Co. Inc. (KKR, Financial), receiving big bailout checks, there may be little alternative. As Bethany McLean commented in Vanity Fair on April 9, private equity may be too big to fail:
“Unfortunately, there isn’t really an alternative to providing private equity with federal funds. Like the big banks in 2008, private equity is holding us all hostage.”
With so many jobs – and so much of the economy – reliant on private equity owners, it cannot be excluded without broader ramifications – including risking considerable damage to already struggling pension funds.
Verdict
Private equity is likely to enjoy a bailout from the federal government in some form or another. It will likely come with strings attached, which may put further pressure on an industry already starting to face serious questions about its ability to actually deliver the superior returns it promises.
Investors with exposure to PE, either individually or through a pension fund, should pay close attention to this story as it develops.
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