(The Telegraph) - Private equity’s “extraordinary 40-year run is finished” as an era of cheap debt is replaced by higher interest rates, City figures have declared.
Guy Hands, the founder of private equity (PE) firm Terra Firma, says the industry is at risk of facing a similar reckoning to the securitisation market, which he described as the “crack cocaine” of money markets in the run-up to the global financial crisis.
Meanwhile, City grandee Archie Norman, a non-executive director at Bridgepoint and chairman of Marks & Spencer, says higher interest rates mean bosses will have to stomach lower returns because debt is “an important part of their [PE firms’] success”.
The Bank of England last month raised interest rates for the 13th consecutive time to 5pc, the highest level since 2008.
Threadneedle Street has been increasing the bank rate to rein in soaring inflation, which threatens to become embedded in the economy as domestic costs such as services surge.
PE funds, the architects of the leveraged buyout, are among those most exposed to rising interest rates with the cost of servicing debts in portfolio companies now much more expensive.
The sector will now have to “find alternative sources of capital” if it is to survive, according to Stephen Quinn of 17Capital. “Rising interest rates absolutely are an issue,” he adds.
Prophecies from critics that the world’s buyout barons face retribution have abounded ever since PE exploded onto financial markets in the 1980s.
Vincent Mortier, chief executive of Amundi, Europe’s biggest asset manager, has previously compared PE to a “Ponzi scheme” that will unravel in the next three to five years.
But as one veteran analyst says: “The trouble is, people have been saying this for the last 40 years – and PE has just kept growing.”
Terra Firma’s Hands recalls the early 1980s when US government interest rates were at almost 16pc.
“While it was extremely difficult to get PE deals done in the early 1980s, those deals done could be refinanced at lower interest rates with an equivalent reduction in the cost of capital,” he says.
“[This] meant that even without any increased efficiencies or top line growth, deals were profitable.
“We now face a reverse situation and the recent increases in interest rates and resulting increase in the cost of capital means that for a PE deal to work you need either substantial increases in efficiencies or huge top line growth.
“In short, PE, from having had a benign environment for most of the last 40 years, is now facing the exact reverse. This will be extremely challenging to deal with.”
Norman is less pessimistic, arguing that debt remains an important part of the success of PE.
“With interest rates rising, returns for PE may reduce, but of course public market returns are also coming down,” he says.
“Having said that, if you talk to any of the big endowment funds, the asset allocators, they will tell you that in order to make a competitive return on your portfolio in the last 10 years or in the next 10 years they need a significant PE allocation.
“PE has outperformed on average and will probably continue to do so.”
Norman says that PE has already been suffering from higher interest rates for some time – in many cases, well before base rate increases were implemented.
“In the last three years a lot of portfolio companies have been borrowing not from banks, but from credit funds already at rates of 5pc to 7pc. So the increase in interest rates is probably less impactful than one might think it is,” he says.
Hands, however, believes that there is a “huge amount of pain” to come which will be concentrated among some firms, rather than being evenly spread across the industry.
He adds: “The change in the interest rate environment has happened much faster than anyone expected.
“There will be relentless pressure across all aspects of society and some businesses will go over the cliff.”
The pressure on PE has been building for the last 18 months, pre-dating central banks’ decisions to increase interest rates to combat soaring inflation.
Corporate auctions for companies including the high street pharmacy chain Boots and Motor Fuel Group, Britain’s biggest forecourt operator, failed to attract the multi-billion pound bids their owners expected in the spring of 2022.
And just last week it emerged that Canadian investor Brookfield was struggling to garner interest in Center Parcs, which it has recently put up for sale for about £4bn.
Quinn, of 17Capital, says the “mismatch on buy and seller expectations” after economies emerged from the Covid pandemic compounds matters. He suggests it is almost as if PE managers are unwilling to accept that their assets are not worth what they think they are.
Quinn adds: “If debt is going to cost more and there is less available, then logically funds cannot pay the same price as when interest rates were almost 0pc and debt was more accessible.
“It is part of the reason why the number of exits is down materially in the last 12 to 18 months. And the number of new deals in PE is also down materially. That is why alternative liquidity sources such as NAV finance or the secondary market have come into play.”
Secondary deals – where one PE firm sells a portfolio company to another – are also nicknamed “pass the parcel” assets.
Historically, around one in five assets are passed from one buyout firm to another.
The logic is that a smaller PE house takes a business so far before passing it onto a larger fund that can turbocharge growth further.
Norman says: “All PE portfolios have to exit, typically within 10 years, and to be successful most of it within six. When the IPO market is effectively closed – and when there are not a lot of trade buyers around – you have to find an alternative exit.”
Quinn says that the number of secondary deals has now risen to about one in four. And the growing reliance on pass the parcel deals could be the canary in the coalmine for PE.
Whether parts of the PE “ponzi scheme”, as Mortier puts it, will come crashing down is likely to hinge on whether the industry’s own investors, their limited partners, stick by them.
One analyst, who began his career during the 1980s buyout boom, says: “As long as investors continue to buy the story that PE has access to some kind of special magic, for which investors are prepared to overpay in terms of fees, the juggernaut won’t be stopped.
“Investors have been hurt in cyclical downturns before and yet PE has continued to grow. One reason is that many investors don’t really understand where their returns come from.”
Norman says: “Leverage is still an important part of many PE investments. The PE people often talk as if they’ve got a different model of management or governance. It is different but not that different.”
Studies have suggested that if the S&P 500 of the US’s top listed companies were injected with the same amount of debt as PE, the returns would be comparable.
Hands fears the worst, however, comparing PE to the pre-credit crunch boom in securitisation – where loans and other investments were packaged together and sold on to investors on the assumption that they were buying less risky assets.
“PE is facing an equivalent issue to that faced by securitisation in 2008. Securitisation had become the crack cocaine of the financial markets,” he says.
“It is quite possible that most PE deals will survive ‘The Great Interest Rate Hikes of the 2020s’ very well.”
But the founder of Terra Firma – one of Europe’s best-known PE houses – fears many firms could go to the wall.
“Will PE disappear? Of course not. But will it become a less secure and less attractive place to invest and work? Absolutely,” Hands says.
“Since 1980, it has been the best place to invest and earn money globally. That extraordinary 40-year run is finished and the global business school students who are financially motivated should start looking for a new go-to career.”
By Oliver Gill
