This article first appeared in The Edge Malaysia Weekly on January 20, 2020 - January 26, 2020

IN the 1990 film Pretty Woman, a Hollywood hooker played by Julia Roberts queries the leveraged buyout (LBO) investor played by Richard Gere about what he does for a living. “You don’t make anything, build anything?” she asks him in one of the movie’s more memorable scenes. His deadpan response: “I make money.”

Even though total global debt with sub-zero yields has fallen from a record US$18 trillion just six months ago to US$11 trillion (RM44.7 trillion) currently, there is still a huge and growing appetite for alternative assets like hedge funds, private credit as well as private equity funds.

Institutional investors like insurance firms and pension funds are chasing alternatives because they do not believe traditional assets such as equities, bonds and real estate can give them the kind of returns they need to match their long-term liabilities in an increasingly lower-for-longer interest rate environment.

To be sure, private equity or PE is just a rebranding of the 1980s LBO industry. PE is capital made available to private companies or investors to help develop new products and technologies, expand markets, boost working capital, make acquisitions or strengthen a company’s balance sheet with the deft use of leverage.

University endowments, giant pension funds, sovereign wealth funds, family offices and high-net-worth investors looking to partake in long-gestation, or early-stage and higher-risk investment to get outsized returns, are increasingly turning to alternative assets like PE.

Since 2009, investors have poured US$5.8 trillion into PE globally. Over six million Americans — or 5% of the total workforce — are employed by 35,000 PE fund-controlled firms. PE firms now have a total cash pile of US$1.45 trillion that they can invest around the world.

Last year, PE giants such as Apollo Global Management, Blackstone Group, Carlyle Group and KKR & Co raised US$600 billion in new funds globally, according to Preqin, an alternative assets consultancy.

A lot of the new money is also being raised in Asia specifically for deals within the region. A total of US$250 billion in PE dry powder is now available for Asian deals. Investors are pouring money into PE funds because of low or, indeed, even negative interest rates, the recent history of underperformance by global hedge funds, and low and falling expectations of public market returns.

PE takeovers don’t save firms

In recent years, PE has been the biggest acquirer of two prominent distressed sectors — newspaper and retail assets — globally. But the truth is, while PE firms have collected tens of billions in fees, they have yet to save a single newspaper or retailer.

PE firms took over struggling newspaper publishers as well as retailers that had been disrupted by the internet and e-commerce. They aggressively cut costs, sold assets and forced the acquired firms to load up on debts, bankrupting them in the process.

A case in point: the 2008 takeover of Tribune Co, publisher of the Chicago Tribune and Los Angeles Times, by billionaire property tycoon Sam Zell. Within a year, the newspaper group was forced to file for bankruptcy, saddled with US$13 billion in debt.

Another was the takeover of retailer Toys “R” Us. PE giants Bain Capital and KKR stuffed US$5 billion in additional debts into the toy retailer’s balance sheet before declaring bankruptcy 18 months ago.

Other retailers such as Sears department store, Payless ShoeSource and optician Shopko, as well as literally hundreds of retailers and local small town newspapers, have borne the brunt of PE’s slash-and-burn tactics.

Massachusetts senator Elizabeth Warren, a left-leaning Democratic presidential candidate, last year tabled the Stop Wall Street Looting Act, a reform bill that seeks to curb deal-making by PE giants.

“Private equity firms want you to believe you’re not smart enough to understand their business model,” she said in a tweet as she tabled the bill. “But it’s pretty simple: Take over companies and loot ’em.”

Warren argues that PE firms take dividends out of the system, pay themselves big bucks and ultimately lay much of the risks on the employees of the firms they acquire.

The PE industry, she says, encourages banks to lend to businesses that are already swimming in debt, thereby making bad situations worse. “We need to shut down the Wall Street giveaways and rein in the financial industry so it stops sucking money out of the rest of the economy,” Warren said recently.

Because managers of PE firms make money hand over fist — no matter what happens to the underlying firms — she argues that regulators need to protect employees’ pensions and retirement funds if a PE-backed LBO goes wrong.

The US Chamber of Commerce, however, says Warren’s anti-PE bill would result in the loss of 26 million jobs, US$475 billion in tax revenues and US$3.4 billion in lost investor capital. Indeed, in a worst-case scenario, the chamber argued in a recent statement, America’s huge PE industry would simply cease to exist.

“We are not the bad guys we are made out to be,” says billionaire Stephen Schwarzman, founder and CEO of the listed Blackstone Group, the world’s largest alternative assets manager with US$545 billion in assets under management. “We are not looting. We just buy assets or companies, and try to make them better because eventually, we just want to sell them to someone else for more,” he argues.

After they take over a company, PE firms will typically bring in a new management team, add complementary companies and aggressively cut costs. “If we were looting, nobody would give us money to do what we do,” Schwarzman said during his recent book tour across America.

For now,  a  flood of money is driving up prices for private firms that PE funds are targeting. Because PE is paying through the nose for assets these days, the bar for them to perform is incredibly high.

Aside from a small bunch of tech companies that have stratospheric valuations, small and medium-size listed firms currently trade at fairly inexpensive valuations.

The Russell 2000 Index, the barometer for smaller firms, trades at 12.5 times 12-month forward earnings compared with 18.5 times for the benchmark Standard & Poor’s 500 (S&P 500).

Twenty years ago, PE firms were able to buy family businesses or small listed firms that sold at single-digit earnings multiples, paying four or five times adjusted earnings before interest, taxes, depreciation and amortisation, Dan Rasmussen, founder of Verdad Capital in Boston, told The Edge in a recent interview.

Rasmussen knows what he is talking about. He worked at Bain Capital, a Boston-based PE firm, and later at hedge fund giant Bridgewater Associates, before setting up his own fund. A graduate of Harvard and Stanford, Rasmussen has emerged as an outspoken critic and a key thorn in the side of the PE industry.

Despite all its current problems, PE was once incredibly profitable. Between 1980 and 2006, PE firms in America were purchasing companies at a 40% discount to S&P 500 valuations, or up to a 30% discount to Russell 2000 valuations, generating very attractive returns and significantly outperforming other asset classes globally, says Rasmussen.

They bought cheap little companies, provided them much-needed capital and helped them grow before selling them. When PE firms were buying stuff cheap and their assets had multiple expansions through better margins, they were able to do well, he says. But as assets become expensive, they just increase the debt load even as margins contract, setting up the PE firm for failure.

Since 2006, PE returns have been less than spectacular compared with what investors could have gotten elsewhere. Over the past five years, hedge funds posted 5.5% returns, compared with 14.4% for PE and 17.9% for the large cap US tech barometer, Technology Select Sector SPDR ETF.

These days, PE deals are three times more expensive and, as such, it is a lot harder even for the likes of Blackstone or Carlyle to make outsized gains. The way Rasmussen sees it, “PE is probably the most dangerous and risky asset you can invest in today.”

Reason for PE failure

So, what have the PE firms gotten wrong?

For one, Rasmussen says they do not understand the credit quality of their investment or the credit risk of their underlying portfolio companies. Credit rating agency Moody’s Investors Service estimates that of all the PE funds bonds it rated, only 2% are investment grade.

“PE guys don’t understand the amount of leverage that has been piled up in the companies that their funds own,” he says. It is often leverage upon leverage upon leverage, he argues.

When things go bad, highly leveraged companies go bankrupt, which, in turn, forces PE firms to start firing people. And when that happens, the economy takes a hit, unemployment goes up and banks’ bad loans balloon.

What do PE firms do behind the curtains with private companies that they could not do in the public space? And why do they want total control of their portfolio firms?

It is all about increased leverage. PE firms want total control so they can change the capital structure of their portfolio firms. Rasmussen looked at 390 PE deals that issued publicly traded bonds over the past five years.

After being taken private, revenue growth of the firms slowed at 54% of them, 40% of firms saw their margins contract during the period and 55% saw a decline in capex spending as a percentage of their total sales. PE funds are supposed to help to improve portfolio companies, yet they slow down very rapidly after coming under the PE umbrella.

A recent study by MIT found that PE managers often exaggerate performance.

Berkshire Hathaway CEO Warren Buffett has long criticised the PE industry and its use of questionable metrics. Billionaire investor Howard Marks of Oaktree Capital Management has been critical of the way PE firms use internal rate of returns, or IRR, to pad up their performance.

IRR measures how a portfolio performs on a dollar-weighted basis and adjusts for cash flows such as capital calls and fund distributions. “Private equity guys are fantastic storytellers who weave a great tale,” says Rasmussen.

Senator Warren’s rhetoric has, however, not dampened the enthusiasm for PE funds in the US and around the world.

“Institutional investors still want to invest in PE funds because they believe they can get incredible returns,” says Rasmussen.

Because of its past track record, the PE industry has had great PR, which in turn has made raising money a piece of cake. Yet, as more money pours into PE funds because a vast majority of institutional investors are bullish about their ability to generate outsize returns, the more investors should worry, argues Rasmussen.

The three key ingredients often cited for financial panic are consensus, leverage and illiquidity, he notes. The current enthusiasm for PE encompasses all three.

Assif Shameen is a technology writer based in North America

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