By Austin O'Toole
In an attempt to gain more revenue and outperform the markets, more high-net-worth individuals and institutions are turning to private equity as an alternative investment. At a glance, this alternative appears to be in an investor’s best interest. Over the past five years, private equity funds have beaten the S&P 500 and Nasdaq by an average of about 7.33%. Not only that, but if you look at 2014 alone, according to Bain Capital, exit buyouts were at an all time high of about $450 billion. Also, fundraising for firms such as Preqin hit $500 billion, and AUM hit an all time high of about $3 trillion. Clearly, these returns have provoked an interest in many investors; however, this all may be coming to an end as asset valuations in many sectors have become increasingly overvalued.
As displayed in the graph below, the assets in private equity firms have grown exponentially since 2000; though, many firms are beginning to realize that their valuations are in fact incorrect. Companies, such as Fidelity, have reevaluated their investments and have decreased valuations by as much as 25%. According to Renaissance Capital, 60% of IPOs that went public in 2015 are now trading below their IPO price. Not only that, but also IPO returns were down 4% from their IPO price in the third quarter, which was the only negative quarter since 2011. These “unicorn valuations” have created an unstable environment that is on the brink of collapsing.
There are three main reasons private equity’s bubble will “burst” in the upcoming years. First, the federal government is beginning to increase interest rates. These higher interest rates correlate to higher costs of capital, which in turn will reduce the returns many private equity companies will obtain. This lower equity impedes firms from generating additional revenue.
Second, as Andy Kessler from the Wall Street Journal has pointed out, banks have been decreasing their lending for leveraged deals over the past few years. Regulators have been starting to refuse to give out loans more than six times earnings before interest, taxes, and depreciation. This ultimately hampers a private equity firm’s ability to make deals and raise revenue to purchase companies.
Third, private equity hinders the economy. A private equity firm’s main objective is to generate as much revenue as possible; therefore, many of these firms cut back on innovations, such as new products and services. While they do create wealth for pension funds, private equity firms can reduce wealth in the economy, by as much as 0.5%-1%.
It is no longer a matter of if this bubble will burst, but rather when it will. Marc Andreessen, cofounder of the Silicon Valley venture capital firm Andreessen Horowitz, stated, “When the market turns, and it will turn, we will find out who has been swimming without trunks on.” When this bubble bursts, it will have a detrimental impact on the economy, similar to that of the Dot-com bubble in 2000. When the market turns, two major events will happen. One, companies will increase layoffs, seeing as they have a reduced amount of revenue to cover expenses. As what happened during the Dot-com bubble, many of these companies will run out of capital and will either be acquired or liquidated. Two, this burst will send prices falling precipitously and will wreak havoc on late-coming investors. This downward shift reduces spending power, which could, in worse case scenarios, sedate the economy and cause a recession. Although I do not believe that this downward trend will occur in the near future, history suggests that we will see the private equity bubble burst if company valuations do not become more realistic.