PE gets one over on hedge funds
By Paul Mackintosh - 04/02/13
I was not lucky enough to get to Davos this year, but I can bring back some gems from it in the form of a World Economic Forum Report: ‘The Future of the Global Financial System’, produced with Oliver Wyman and introduced by Carlyle’s David Rubenstein, co-chair of the report’s steering committee. The report gives proportionate focus to private equity, and makes one of the most authoritative forecasts available of the near-term development of the industry.
The buyout bubble prior to 2008 came at the culmination of a secular ramp-up of debt availability worldwide and especially in the US, where, according to the report, “total credit market borrowings grew from approximately 160% of GDP in 1980 to over 350% in 2008.” The financial services sector alone accounted for 115% of that debt by 2008 – while interest rates plunged, with yield on ten-year US Treasury Notes falling from almost 16% to just over 4% over the same period. Hedge funds and private equity firms were particular beneficiaries, accumulating over US$4 trillion of AUM by end 2007. “Searching for yield in a low interest rate environment, institutional investors rewarded capital-intensive, highly leveraged businesses,” the report succinctly puts it.
Needless to say, this four-decade upsurge is not likely to recur any time soon. “In hindsight, this recent picture of macroeconomic and financial services growth was built on a foundation of imbalances, namely expansionary monetary and fiscal policy, excessive deregulation and ill-considered use of credit and leverage,” the report states.
And consequences for private equity investment are immediate. Yes, continuing low interest rates are going to help leveraged buyout (LBO) financing. But, the report points out, “private equity firms that had recently been on an acquisitions binge are now suddenly faced with the prospect of portfolios under stress and limited exit opportunities.” And to the present challenge of managing out these stressed portfolios, it added that “adapting their business models to a deleveraging world where cheap financing will be hard to find.”
If there is any mitigation, it is that “unlike the hedge fund industry, private equity has not emerged as an amplifier of systemic risk and is thus not a likely candidate for significant regulation.” But the industry continues to be burdened by over $800 billion of uninvested capital left over from the boom years, while most LPs are at or over their target allocations. Fresh capital, then, may be far harder to come by. A new class of “unconstrained investors” – a.k.a. family offices and SWFs – may come to the industry’s rescue with fresh fund commitments – but may also create a new class of rival direct investors. At least PE GPs can take some moral comfort from the report’s comparison with hedge funds, where “there is a great deal to be learned from the private equity sector in aligning the long-term interests of the manager/general partner with those of the investors/limited partners,” the report concludes.