You Have Been Warned: Private Equity’s Glory Days Are Over
In an opinion piece in the Wall Street Journal, Andrew Kessler, former hedge fund manager and financial writer, makes the case that private equity’s best days are behind it. While Mr. Kessler cites all of sorts of reasons, the subtitle to his column succinctly captures an argument I’ve been making in this blog: “Too many funds are chasing too few opportunities, and many of those will be too expensive. It won’t end well.”
Moreover, as Mr. Kessler points out, the tailwind that has boosted private equities results is in the process of shifting. Interest rates are about to rise. Banking regulators are clamping down on lending for leveraged transactions. Congress, including Republicans, is looking to limit the deductibility of interest payments by corporations. The ingredients are coming together for a major shift in the prospects of private equity.
Mr. Kessler makes a fourth argument about the likely decline of private equity. He suggests that private equity is bad for the economy because it diverts large amounts of cash flow from productive capital into debt service. While I agree that this is a byproduct of private equity investments, I don’t think it is one of the reasons that private equity’s halcyon days are behind it. In my view, the entire financial sector is far too large and drawing way to much capital away from the productive sectors of the economy. However, I don’t think it is going to shrink any time soon.
Although private equity’s best days measured by investment returns are over (and have been over for quite some time), the industry’s ability to continue to raise large funds is going to continue for quite some time. Notwithstanding the mounting evidence that too much capital is chasing too few good opportunities, institutional investors are continuing to pour money into private equity. Dow Jones LP Source reported that the industry raised $266 billion last year. And, Warburg Pincus has just announced that it is raising a $12 billion fund, only two years after raising an $11 billion fund. According to a report from Bain and Company, PE firms have $1.1 trillion in available capital (known in the investment world as “dry powder”) for new deals.
Public pensions and sovereign wealth funds aren’t forward thinking investors. They tend to follow trends and one another in chasing investment opportunities. As a result, they will continue to fuel private equity until the returns go from disappointing to alarming. Ironically, when the returns finally look awful, institutional investors will finally have a golden opportunity to make money in private equity. However, very few will have the foresight, will, or courage to make commitments.
Mr. Kessler’s column provides a fair warning to investors. I’m betting that very few investors will heed it.