Public problems for private equity

Episode Summary

Executive Summary: This episode of Unhedged analyzes the challenges facing the private equity (PE) industry, which enjoyed high returns for decades due to low interest rates, cheap debt, and abundant low-hanging fruit. Now, rising rates and intense competition are squeezing returns, pushing firms toward exotic financial engineering—like borrowing at the fund level—to prop up portfolio companies and delay selling in a weak exit market. Investors worry these tactics mask underlying distress and erode the 15-20% returns they expect. The hosts explore the structural shifts making the PE model harder to sustain, though they note that institutional investors may still value PE for its non-marked-to-market stability, which can enhance portfolio risk-adjusted returns despite declining absolute performance.

Main Topics: Definition and mechanic of private equity (leveraged buyouts) (Priority: 4/5): Explains the classic LBO model: a PE firm uses a small portion of its own capital and a large amount of borrowed money to acquire a company, much like a homeowner with a mortgage. The debt is put onto the acquired company's balance sheet, generating controversy around loading companies with debt. Historical tailwinds for PE: low rates and easy pickings (Priority: 5/5): PE benefited greatly from falling interest rates and rising asset prices over the past 20-30 years, creating a favorable 'water' to swim in. Early deals also capitalised on poorly managed public companies and undervalued small firms, providing high returns. Current headwinds: higher rates, competition, and return compression (Priority: 5/5): Rising interest rates increase the cost of debt and depress asset values. At the same time, massive inflows into the industry have intensified competition for deals, pushing up purchase prices and lowering expected returns even before the rate shift. New financial engineering: fund-level borrowing and company debt extension (Priority: 5/5): PE firms are increasingly borrowing at the fund level (rather than company level) to secure cheaper debt and prolong holding periods, avoiding sales in a weak IPO or M&A market. This tactic alarms investors because it can magnify losses if portfolio companies default. Investor concerns over fine print and creditor sophistication (Priority: 3/5): Large institutional investors are scrutinising fund contracts to limit financial engineering. Creditors (often other PE entities) are becoming more sophisticated, pushing back against changes in debt structures that shift risk. Should institutional investors stay in PE? The 'not marked to market' paradox (Priority: 4/5): Despite falling returns, PE may remain attractive because its valuations are stable (not frequently marked to market), which can mathematically improve the risk-return profile of a total portfolio—even if absolute returns become mediocre. Short segment: Birkenstock stock and dollar dominance (Priority: 2/5): Rob goes short Birkenstock, arguing its PE-optimised IPO and peak fashionability will lead to a price decline. Ethan goes long the dollar, citing entrenchment as the global reserve currency and the U.S. economy's size/strength.

Key Arguments: Private equity's past success was largely due to a falling-rate environment and low competition; both conditions have reversed, making the model harder to sustain. To avoid selling assets at low prices, PE firms are using 'exotic' debt financing at the fund level, which can improve short-term cash flow but increase systemic risk and reduce transparency for investors. The stability of PE valuations (not marked to market) creates a misleadingly smooth return stream that inflates risk-adjusted portfolio metrics, even when underlying returns decline. Creditors in PE deals are growing more sophisticated, eroding PE’s historical advantage in contract design and negotiation.

Data Points: Interest rate level: 5+ percent - Current cost of funding, mentioned as dramatically higher than in the low-rate environment that benefited PE for years. Private equity return expectations: 15-20% - The high returns that institutional investors have historically expected from PE, which are now under pressure. Default rate trend: slow but steady increase - Nationwide default rates rising, adding pressure on PE-owned companies and potentially magnified by fund-level borrowing. Interest rate on company-level debt: teens (13-19%) - The cost of borrowing for struggling PE-owned companies at the company level, much higher than fund-level borrowing costs. Length of PE's favourable period: 20-30 years - Reference to the long period during which PE has been one of the best returning asset classes.

Pivotal Quotes: "I think a lot of us, investors, people in the press, are looking on and saying, We remember that old story about how private equity funds bought companies and made them better. Yeah. But now you're doing these sort of financial engineering card tricks, and we're wondering if there is something unfortunate going on behind the scenes." — Ethan Wu / Antoine Gara (paraphrased): Describes the shift from operational improvement to financial engineering as a reason for investor unease. "The fund is much bigger than any individual company. And of course, the change in the asset price environment is implicated as well. Why do they, these little companies owned by PE or these medium-sized big companies owned by PE, need to borrow more money? Because the PE fund does not want to sell them right now because they don't think they would get a good price." — Robert Armstrong: Explains the motivation for fund-level borrowing: unwillingness to sell in a weak market and the need to prop up portfolio companies. "It used to be that private equity had the lawyers with the shiniest suit and best, most slicked back hair. And that's changing. A lot of these companies now have all kinds of very sophisticated people taking a look at how they can get the most money. And someone has to lose at the end of the day." — Robert Armstrong: Highlights the increasing sophistication of creditors, eroding PE’s historical edge in deal structuring. "Acute listeners will notice that there is a slight flavor of the absurd to all of this. That this asset class is valued more highly because you know less about its true underlying value, which is the exact opposite of what you'd expect." — Robert Armstrong: Points out the paradoxical appeal of PE's non-marked-to-market valuation, which boosts portfolio metrics despite hiding true volatility.

Implications: Institutional investors should reassess expected PE returns downward and watch for rising defaults and fund-level leverage. The industry's shift toward financial engineering may lead to greater scrutiny and investor pushback. Despite lower returns, PE’s valuation stability may still attract capital, but at the cost of increased opacity and systemic risk.