WWRR Vol.2.015

Christopher Wood christopher.wood@clsa.com +852 2600 8516
Meanwhile if there is an area of American finance likely to blow up in a coming downturn, where the
dynamic is driven by the unwind of QE-driven asset inflation, it is most likely to be the so-called
“private equity” industry which has been the biggest winner in this ten-year cycle since the global
financial crisis. The best summary of this industry in a single sentence was written by an old friend
of GREED & fear’s, Michael Lewitt, in the September edition of his monthly report, The Credit
Strategist: “Private equity often consists of nothing more than substituting debt for equity on a
company’s balance sheet, firing employees, cutting R&D and capex, and paying out a bunch of fees
to private equity firms (and in exchange for this they get a carried interest tax break!)”.
GREED & fear could not put it better. Meanwhile, GREED & fear recently came across an interesting
critique of private equity which is worth reading (see American Affairs Journal article “Private Equity:
Overvalued and Overrated?” by Daniel Rasmussen, Spring 2018). The writer of this article reports
how his firm, Verdad, compiled a comprehensive database of 390 private equity deals. In 54% of the
transactions examined, revenue growth slowed. In 45%, profit margins contracted, and in 55%,
capex spending as a percentage of sales declined. The author went on to note that there is a big
difference between what private equity used to do, namely buying companies at 6-8x Ebitda with
debt at a reasonable 3-4x Ebitda, and what private equity does today, which is buying companies at
10-11x Ebitda with debt at 6-7x Ebitda. In a further sign of excess, Rasmussen describes how
private equity funds are now coming up with so-called “long-dated funds” with longer lockup
periods, and buying companies from other funds they manage. The author writes: “This shell game
of overpriced deals getting pawned off to other pools of capital is evidence of rising private equity
froth”.
Figure 16
Global private equity dry powder (cash reserves)
1,200
(US$bn)
Global Private Equity Dry Powder
1,000
800
600
400
200
0
Dec 07 Dec 08 Dec 09 Dec 10 Dec 11 Dec 12 Dec 13 Dec 14 Dec 15 Dec 16 Dec 17 Sep 18
Source: Preqin
The excesses have only grown since this article was published with the latest estimates GREED &
fear has read indicating that the global private equity industry now has US$3.1tn in assets under
management with US$1.1tn in cash, or so-called “dry powder”, to invest (see Figure 16), according
to private equity data provider Preqin. The obvious problem in the making is the debt the private
equity industry has taken on to finance these deals.
This leads on to the risk highlighted by the ever sensible BIS research department in its quarterly
review published in September. This is the resurgence in leveraged finance, comprising high-yield
bonds and leveraged loans, which has doubled in size since the financial crisis. Total leveraged
finance rose from US$1.25tn at the end of 2008 to US$2.79tn at the end of 2Q18, while within this,
Thursday, 22 November 2018 Page 8