Some Asset Owners Don’t Want to be Chumps in Big Buyout Funds

Posted on 05/12/2023

For well over a decade in the U.S. stock market, profitless companies, much less companies not generating substantial revenue were able to go public raising fardels of cash. Examples of this in recent times include the IPOs of widely-reported Rivian Automotive and Robinhood Securities. Many of these IPO investors such as sovereign wealth funds, pensions, large mutual fund companies such as Fidelity, and others were eager to get in early as markets chugged upward before Federal Reserve tried to contain inflation. This unique period of pre-IPO companies having sizable negative gross margins were a partial result of easy, loose monetary policy. As interest rates remained low and money was printed, business models became “dreamier”, as rates on many Western government bonds were lackluster. A major beneficiary group from the global financial crisis of 2007-2008, were buyout and growth equity investors. The Federal Reserve’s gift of nearly free money bailed out companies that should have failed in most “normal” market conditions. Buyout firms generously benefitted also from employing more aggressive leverage ratios and eroding some loan covenants and restrictions in specific deals. In all of this, private equity firms benefitted from a hungry IPO market and low interest rates. Bottomline, private markets activity and valuations in 2021 were an aberration driven by a number of factors including low interest rates, post-Covid economic rebound, and robust public equity markets

The first shoes to drop when the Federal Reserve started to raise interest rates was the cryptocurrency crash, the fall of SPACs, and faults in the venture capital industry and the general stock market. Indoor farming, fake meat, pushing electric vehicle trucks down hills, and “payday” fintech lenders seemed to be not so cool. So far in 2023, new investments and exits in private equity are incrementally slowing, particularly in venture capital, with exits suffering the most. Mubadala Investment Company and the Public Investment Fund’s investment in the US$ 100 billion SoftBank Vision Fund became unappetizing. For the fiscal year-ended March 31, 2023, SoftBank’s Vision Fund segment reported a record loss of 5.3 trillion Japanese yen (around US$ 39 billion). A lack of robust M&A activity and IPO markets will drive longer hold periods for investors. This will increase the need for follow-on rounds and higher failure rates with regard to portfolio companies.

During this bloodbath of venture startups imploding, private equity firms revved their marketing engines to promote buyout funds as public market investments such as stocks faltered in 2022 and 2023. The selling point is that private equity is “private” – no public prices and the volatility issue would be solved to smooth returns. However, the cost of buyouts and the continual rising of interest rates puts a damper in the PE model. Without leverage and cheap financing, PE returns might not be as attractive as promised. In a 2020 academic paper by Ludovic Phalippou of the Saïd Business School, he found that private equity funds had returned about the same as public equity indices since at least 2006. With rising interest rates, PE firms are having to be more disciplined, and already many of the giant PE firms like Apollo Global Management, Ares, KKR, and Blackstone have focused towards private credit and marketing products to private wealth clients. Private equity buyout strategies could be facing a period of lower investment returns as the the cost of capital rises. Carlyle Group and Blackstone have lowered their fundraising expectations in private equity versus other asset classes.

According to SWFI data, over a period of a decade, pensions and SWFs still allocate to buyout and growth equity strategies. While PE players like Carlyle Group struggle to raise traditional buyout funds, Thoma Bravo LLP, Silver Lake Partners, and other tech focused PE firms have raised billions in this environment. Sovereign funds and pensions don’t want to catch a falling knife. CalPERS remembers TPG Capital losing its entire US$ $1.35 billion investment in Washington Mutual Inc. (WaMu) in 2008. TPG at the time didn’t even know when it was happening. The Office of Thrift Supervision had seized the bank, keeping WaMu and its board of directors, and left David Bonderman in the dark. Sector-focused PE firms, at least in favorable sectors at the moment, have so far defied a bit of gravity. However, on the issue of PE funds in general, sovereign funds like the Abu Dhabi Investment Authority (ADIA) and Singapore’s GIC Private Limited crave more co-investment opportunities. This is while PE firms are shifting their marketing focus toward private wealth and smaller pensions, in which information asymmetry is greater.

Tech Companies
Tech companies got away with lofty valuations and the decline of these valuations in the last twelve months has out a spotlight on these very companies. In November 2021, Riverbed Technology filed for Chapter 11 bankruptcy protection with a view to implementing a “prepackaged” financial restructuring plan to eliminate debts of US$ 1.1 billion. Riverbed Technology blamed the bankruptcy on issues related to the COVID-19 pandemic. Riverbed was taken private by Thoma Bravo and Ontario Teachers Pension Plan at the end of 2014 for around US$ 3.6 billion.

Orlando Bravo, a Co-Founder of tech private equity firm Thoma Bravo LLP, tweeted on May 11, 2023, “Going public used to not be very attractive to PE as 1. You lose control of your Balance Sheet to do M&A and 2. mgmt starts playing a different game (the beat & raise game and stock comp incentives). But now, with 13% cost of debt and public shareholders wanting cos run for profitable growth — the dynamics have changed.”

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