By Andy Kessler at The Wall Street Journal
Private equity is done. Stick a fork in it. With Kraft singles and Heinz ketchup as toppings, there are many signs that private equity has peaked as an asset class.
Sure, private equity is pervasive, which is one of its problems. According to Dow Jones LP Source, 765 funds raised $266 billion in 2014, up 11.7% over 2013. Ever since David Swensen, the investment manager of the Yale University endowment, almost 30 years ago began successfully allocating outsize portions of the portfolio to “alternate” assets, especially private equity, the so-called Swensen model has been widely duplicated. Last week the Stanford endowment named Swensen-disciple Robert Wallace as CEO. There is a lot of capital chasing similar deals.
When it comes down to it, private equity is pretty simple. You buy a company, putting up some cash and borrowing the rest, sometimes from banks but often via exotic instruments that Wall Street is happy to sell. Then you manage the company for cash flow, making sure you can make interest payments with enough left over for fees and investor dividends. With enough cash flow, you either take the company public or sell it to someone else. And how do you generate cash flow? You can expand the company, but more likely you slash costs, close divisions, cut staff, curtail marketing, eliminate research and development and more. In other words, cutting to the bone.
The Swenson model has worked for the past three decades. But it’s a bull-market investment vehicle whose time is done. Here are the main reasons private equity has peaked—the first four are reasonably obvious, but the last one is the killer.
First, interest rates are going up. As they say on “Game of Thrones,” winter is coming. The Federal Reserve will no longer be “patient” on raising rates. This year? Next year? It doesn’t matter. Rising interest rates mean private equity will see higher costs of capital, wreaking havoc on Excel spreadsheets justifying future returns.
Second, as The Wall Street Journal pointed out last week, banks are slowing lending for leveraged deals. Since 2013, regulators have been discouraging leverage above six times earnings before interest, taxes, depreciation and amortization, or Ebitda, a measure of cash flow. Leveraged loans are the lifeblood of private equity; limits are already crimping the ability to do deals.
Third, tax reform is in the air, and interest-rate deductions are on the chopping block. The Lee-Rubio tax reform plan introduced in March “eliminates the deductibility of new debt.” We all pay taxes on interest income, yet companies get tax deductions on interest payments, which only encourages debt. These tax writeoffs are the air that has filled the private-equity balloon for decades. Lee-Rubio may not get anywhere, but the interest-tax symmetry is long overdue and makes enough sense that it could end up in future tax reform. As an aside, this won’t be pretty for debt-laden cable and telecom companies.
Fourth, private equity has been holding back the economy. When you buy out a drugstore chain or car-rental company and load it with debt, you aren’t investing in the productivity of the economy. More often, by cutting back on new products and services, you are removing productivity from the economy. While generating wealth for endowments and pension funds, private equity can destroy wealth in the economy—my guess is 0.5%-1% lower gross domestic product in an already subpar recovery.
And, by the way, of that $266 billion raised last year by private equity, only $33 billion was for venture capital. Venture investments rarely involve debt—they are productivity creators on steroids. With so many billion-dollar-valued startups, it is hard to argue for more venture capital, but instead expect capital allocated to debt-backed investment to peak and decline.
The final reason private equity is done: It is fresh out of fat targets. In October 2007, KKR and TPG and Goldman Sachs bought the utility TXU Corp. for $48 billion. Bowing to the green gods and regulators, who put so many restrictions on electric generation, the deal now known as Energy Future Holdings Corp. has been a bust, filing for bankruptcy last year. So no more utilities.
Earlier this month, Dutch semiconductor firm NXP bought Freescale for $11.8 billion. Freescale, the old semiconductor arm of Motorola, was bought by Blackstone, Carlyle, TPG and Permira in 2006 for $17.6 billion. Firms that are R&D-intensive aren’t great candidates for buyouts, as interest payments squeeze the research needed for innovation. Dell’s buyout two years ago notwithstanding (Dell is more of a packager and distributor), don’t expect many technology buyouts down the road.
So what’s left? Mattress companies seem to change hands regularly. There are a few more food companies beyond Kraft. General Electric is selling off international-lending divisions. But these are too small to soak up hundreds of billions in private-equity capital that the Swenson model now demands.
The reality is that the best companies with high-enough cash flow to pay down interest can’t be bought. No one is buying Apple or Google. But this is also true of cash machines Uber and Airbnb or high-growth companies like Snapchat and Pinterest. Private equity can’t afford them. And with the Dow bobbing around 18,000, public companies are increasingly off the table. Maybe the oil patch? Good luck with that.
Capital will still chase increasingly expensive deals. That won’t end well. So it’s back to basics—creating companies rather than squeezing the last life out of old ones. Just like Wall Street shrinking and curtailing once-profitable businesses, private equity will begin a slow decline. Yes, we’ll see more deals and even a few successes. But the returns from private equity won’t match those of the past 30 years. And capital will flow elsewhere—let’s hope to productive and wealth-creating segments of the economy.
Mr. Kessler, a former hedge-fund manager, is the author of “Eat People” (Portfolio, 2011).