The irritating reality for investors in 2022: The financial world offers safe yields below the rate of inflation.
Predictably, investors hunt for real returns, and they are turning from the transparent and richly priced public markets to private equity funds. But stalking riches in an environment of scant returns, the private equity funds also must edge out further on the branch of risk, chasing venture capital type plays, or ever more leveraged or exotic hard asset and property plays.
Wall Street solons warn this movie may not have a happy ending, but for now nothing seems to stop private equity funds from dramatic expansion: By the estimate of The Economist, private equity managers handle $10 trillion in assets, a sum that has quadrupled in less than 15 years.
Despite the pandemic, supply-chain snags, geopolitical tensions and rising inflation, private equity funds raised an all-time zenith of $940 billion in 2021, reported Wall Street law firm Wachtell, Lipton, Rosen & Katz. With that cash infusion, and returns from earlier investments, private equity titans are seated atop a pile of $2.3 trillion in cash as they enter 2022.
How much money is that? Some opine it is too much. “Private equity funds are raising money faster than they can spend it,” proclaimed Bloomberg.
Why the flood of capital into private equity?
A GLOBAL GLUT OF CAPITAL
In part it is because of the global glut of capital — called the “global savings glut” by the Chicago Fed in a 2021 study, and by many others before that — resulting in depressed returns and richly priced assets the world over. The daily cliche of property mavens, that there is “too much money chasing too few deals,” is largely true, say macroeconomists.
The short story is that savings rates worldwide are elevated, in part due to aging populations, in part because a rising super-wealthy class has more than it can spend, and in part because government policies in much of Asia Pacific (including China, Japan, South Korea and other nations) promote savings. Populations in nations with billions of residents save trillions of dollars more than they spend every year. That money has to go somewhere.
The results of the flood tide of capital are not especially debatable. Even with inflation in the United States jumping near 7 percent, yields on 10-year U.S. Treasuries are less than 2 percent. The price/earnings ratio of S&P 500 blue-chip companies in early 2022 was 25 (based on trailing 12-month earnings), against a long-term median price/earnings ratio of about 15. On the price/earnings ratios, blue-chips are trading like growth stocks, and growth stocks are trading like, well, some might mention the 1990s dot-com bubble.
Values are soaring, and not just on Wall Street. The median price of a house in the United States rose nearly 17 percent in 2021, reported the National Association of Realtors. Meanwhile, average U.S. commercial property prices rose 14.4 percent by early 2022 from pre-pandemic highs, and up about 144 percent from the 2009 nadir of the global financial crisis, reported Newport Beach, Ca.-based Green Street.
So, with public assets fully priced and yields suppressed, individual and institutional investors alike are open to the siren calls of private equity funds, and their promises to beat the market through leverage, or intensive management, or backing the right startups, or quant skills, or all four and more.
EXPENSIVE TASTES
One problem for private equity investors is the assets they are chasing are also escalating in value.
According to a 2021 study by J.P. Morgan Asset Management, in 2015 private equity managers could buyout a company for an average 10-times average EBITDA (earnings before interest, taxes, depreciation and amortization). By 2021 that was up about 12-times EBITDA. But older participants in private equity investing remember the pre-global financial crisis days of 2008 when the multiples ranged from 6.5-times to 8-times EBITDA.
Facing daunting acquisition costs in a world where less-risky investments cost top dollar, private equity funds are migrating into the potentially highest returning, but also riskiest, sector on the money management frontier: venture capital.
VC FOR THEE
The stark numbers are eye popping: In 2021, venture capital investments in the United States topped $330 billion, about double the $167 billion logged in 2020, reported industry monitor PitchBook.
Globally, the picture is the same, but amplified. In 2022, more than $612 billion in venture capital was invested worldwide, a 108 percent increase from 2021, reported FactSet, a financial information service.
It seems like only yesterday the VC industry could nearly be summed up by a simple geographic phrase, as in “Silicon Valley,” or even by a stretch of a thoroughfare, as in “Sand Hill Road.” That was way back when Jeff Bezos was not a household name, but becoming known for wiping out America’s bookstores.
From such un-humble but cloistered beginnings, the VC cottage industry has extended to centers in Boston, Los Angeles and New York and, lately, to such cities as Austin.
Despite recent growth, the VC industry is all but one dimensional on one score: What is dubbed “technology services” won the lion’s share of VC investment in 2021, and if not that, then medical technology, finance and electronic technology.
In general, the catch phrase “technology services” refers to software and cloud/internet connections, and enterprise applications, and is also known as information technology (IT) services, reported FactSet.
While self-driving electric vehicles with exotic battery technology grab headlines, the transportation sector received less than 10 percent of the VC funding received by technology services in 2021. Other sectors, such as retail trade, consumer durables or producer manufacturing, received even less.
For all of its explosive growth, private equity VC money is still largely funneled into the IT industry.
PRIVATE EQUITY AND REAL ESTATE
Of course, real estate has long been a favorite of the private equity crowd, and indeed in 2021 such well recognized names as KKR, Starwood, Carlyle Realty Partners and Oakwood Real Estate, Warburg Pincus and Bain Capital and others all raised additional multibillion-dollar property funds. All told, $175.7 billion was raised by property-oriented private equity funds this past year, the third-highest total ever, reported Private Equity Real Estate.
However, that compares with $186.8 billion raised in 2019 and $184.1 billion raised in 2015, and presents a somewhat pedestrian picture compared to the Niagara of private money flooding VC funds.
To be sure, the choice between real estate or venture investing is not binary, and there is plenty of capital for both segments. Nevertheless, for now it appears the riskier and dramatic VC sector is supplanting the steadier real estate market as the most popular destination for private equity.
LEVERAGE UP
One way to squeeze more out an investment dollar is to leverage up. As investors in real estate know (that is, leveraged buyers), if the market is positive, the returns can be magnified.
Trying to stretch equity and returns, private equity funds are doping up on debt to finance acquisitions, reported S&P Global. Private equity buyers in 2021 conducting mergers and acquisitions spent an average 5.6-times EBITDA to buy an asset, matching the all-time high set in 2018, and well above earlier decades.
Private equity M&A deals topped $4 trillion in 2021, a new zenith, and easily topping even robust pre-pandemic years such as 2018, when $3 trillion in private equity M&A deals were recorded, according to S&P Global.
In 2021, private equity fund managers raised money in chunk-sizes that used to be associated with major national governments. For example, in June of last year, Hellman & Friedman Capital Partners raised $24.4 billion for its X LP fund. That was a single fund by one private equity manager. There were 10 private equity funds that raised $10 billion or more each during 2021.
Of course, piling debt onto acquisition targets — leveraged buyouts — has been a staple in the M&A game going back to Drexel Burnham Lambert during the 1980s, if not before. As interest rates have generally declined in recent decades, the tendency to leverage up and make acquisitions has only increased.
Is too much debt fueling PE corporate buyouts?
The “leverage ratio in private equity-owned companies rises drastically from just around 30 percent prior to PE investment to above 50 percent following a PE-sponsored LBO,” reported Duke University School of Law FinReg blog late in 2021.
Considering “the high levels of debt, both the Bank of England and U.S. regulators have voiced concerns related to systemic risk stemming from PE investments,” said the FinReg blog.
In truth, due in part to lower interest rests, and uncertainty regarding what are “optimal” corporate debt loads, it is not clear whether private equity funds over-leverage their target companies. And private equity operators, as they are presently so money-soaked, appear able to extend more equity to troubled enterprises they have acquired, noted the FinReg blog.
However, even a cursory review of the history of debt and commerce over past centuries reveals recurrent episodes of frothiness and lending, followed by busts. Certainly, private equity asset-buyers in 2021 are stretching to make acquisitions, just as they are pouring money into uncertain, although promising, venture capital prospects.
But the financial world is far from predictable, and perhaps even more so in 2022 as geopolitical tensions mount and promise to upset even the best-laid plans. There may yet be consequences for investors who have borrowed heavily to strike it rich.
REVERTING TO THE MEAN
The further investors venture out on the risk-to-return branch, the greater the chance for a break and fall. The history of financial booms-and-busts often seems as predictable as they are unavoidable. Whenever price/earnings ratios soar too high, whenever property players go high in the capital stack, and whenever venture capital firms flood a sector with startup money, reversions to the mean are likely.
That said, for the broader economy and living standards, the high-tide of investable and risk-loving capital must surely be a positive. In days of yore, getting capital for a startup might have been a combination of knowing the right people, and having a great idea with limited risks.
Today, it may be safe to say that no good VC idea goes un-financed, and many mediocre ones do too. But the surge of capital into new technologies promise to speed the development of better products, services and biomedical treatments — and bring them to market.
Benjamin Cole (7continents7@gmail.com) is a freelance writer based in Thailand.
