Every policy is a response to a particular crisis.
It then stands to reason that big policies which are needed for big emergencies may have an outsized effect on the future. Fifteen years after the 2008 Global Financial Crisis, Private Equity is now facing what is an unsurprising reckoning.
In September 2008 the global economy imploded. The demise of Lehman Brothers exposed the vulnerability of a financial system that had relied too much on derivatives and paid too little attention to risk management. As one after another iconic financial institutions collapsed, it became apparent that what followed would be a 1930s-type of depression. It was fortunate then that the pre-eminent central banker of the times, Fed Chair Ben Bernanke, was an expert in the Great Depression. He immediately printed more money than had ever been attempted, to plug the gaping holes in bank balance sheets. The system would be safe, but global debt would balloon, and rates had to be kept close to zero for many years. Society would be burdened for at least a generation.
So there was a catch. Banks could never extend themselves as much. Still, credit is the lifeblood of the economy, and when it is so cheap it demands a vessel. Private equity stepped up to become the new banking system. In the years that followed 2008 private deals ballooned. The total value of private equity capital invested worldwide in 2022 was an estimated $12tn.
However, the most rapid hike in interest rates in recent history threatens to disrupt a model built on cheap financing. Valuations of private companies which are not traded in the stock market, depend on investors buying consistently at higher prices. An investor buying 1% of a company at £10 million, creates a valuation of £1b, even if the company has only that £10m in capital. Absent a recent last buyer, however, a company is valued based on its earnings. Since most of the companies in that stage are building up, expenses often outpace earnings, so the £1b valuation comes under scrutiny.
This is now the state in which many private equity firms find themselves. Average valuations are falling rapidly, despite many high-quality assets still trading at a premium, and capital is drying up. M&A volumes are the lowest they have been since at least the Euro crisis, a decade ago. According to Bain & Company, fundraising is on track to drop 28% compared to 2022, and the number of funds closed (to new investment) is likely to decline by 50%. Meanwhile, the market is plagued by zombie-private equity firms, which may not have raised new funds in over 10 years, and are simply managing and winding down a current portfolio. Last week, the UK Financial Conduct Authority said it will “examine disciplines and governance” as concerns over the state of the industry mount. And despite proclamations about Private Equity being a more isolated vehicle than banks, a crisis in one financial industry often finds ways to spread to others.
The consequences of a wider, private equity and venture implosion could be significant. Those investment vehicles are grounded in the real, the non—financial economy. Big, listed companies, can afford a temporary slide in their stock prices. After all, their funding came from the IPO or direct borrowing. Stock prices affect shareholders more than businesses – as long as new financing isn’t imminent. But an implosion of the private equity industry could cut financing for fledgeling young businesses altogether. The economic impact would be immediate. Delinquencies and insolvencies would rise, especially amongst those businesses that haven’t got sales off the ground yet. Then, they would spread to healthier and later-stage businesses in their supply chains.
The bigger the shock, the more private equities would seek to pull funding from investments not currently paying off (but could potentially in the future). Unemployment would begin to rise more rapidly, and economic activity would be reduced. An economy with below-trend growth could be tipped into a recession, affecting all sectors.
Behind the gloom, nevertheless, lies always opportunity. Crises best ferment where they are most unexpected. Private Equity, though, has long been in the sights of investors as a potential financial risk. Additionally, the sector has a near-record $3.7tn in “dry powder”, capital ready to be deployed. That capital usually has a time limit. If it’s not used, it returns to its originator. This means that in the following couple of years, deals will have to pick up, or capital will be lost. Lower valuations will provide an extra incentive. And while the sector may struggle for some time and many a fund will have to find higher-hanging fruit than tech, it is worth remembering that banks continue to be shackled, and someone will still need to manage the financing of non-listed firms.
