Merry Christmas, Your Firm May Fail

Move over Dr. Doom, there’s a new gloom-sayer in town. Or rather, across the pond. In a new report, a two European professors, alongside Boston Consulting Group and IESE Business School, have predicted that 20% to 40% of all private equity firms could fail next year.

Called “Get Ready For The Private Equity Shakeout,” the paper goes so far to compare the current PE situation to the subprime crisis. At least in this case, the equity ownership is more transparent.

(By the way, these same authors published a piece called “Why Private Equity Is Here to Stay” earlier this year. What an about-face.)

Predicting that just under half of firms will disappear is widely divergent from peHUB’s take. We said a PE firm shakeout is unlikely, since firms have ten-year investment periods. While the secondary market is booming, there’d never be a crippling wide-spread redemption spree like we’ve seen at hedge funds.

So why do Messrs. Heinrich Liechtenstein and Heino Meerkatt think your industry is about to crumble? Well there’s the “rising tides” argument. It’s true that lots of mediocre firms did great in the last bubble and some may disappear while the tide is out. The paper goes on to argue that the disappearance of new debt, shrinking earnings, lower exit multiples, and reduced LP allocations to PE are the macro-causes. All valid concerns. Enter “flight to quality” argument.

Then we have the existing debt situation, which I take issue with. The paper argues that “Most Private Equity Firms’ Portfolio Companies Are Expected To Default,” and that half of them probably will.

To this I say, really? The study looked at 328 LBO loans and found that two thirds of them are trading at distressed levels. However, the paper makes the false assumption that the debt market is rational right now, and that the underlying companies of these loans are truly underperforming. It’s certainly the case in many instances, but I think plenty of distressed debt buyers would disagree with that assumption. The entire market, including corporate bonds and debt, is trading at its lowest levels in years.

Furthermore, the debt trading market has shown signs of slow recovery since November, with average prices slowly climbing up from the bottom, according to Reuters Loan Pricing. As debt continues to trade at attractive distressed levels and buyers continue to enter the market (not all of them are vultures), I suspect the values of these distressed LBO loans will continue to climb. These levels don’t necessarily dictate a company is doomed for default. A longer hold period, or a lower exit multiple than planned, perhaps.

Either way, the paper advises firms to take three steps to avoid demise: look at operational improvements (no-brainer), take stakes in other PE firms’ troubled portfolio companies (interesting idea), and offer equity in wider corporate arena (we saw how that unfolded for Blackstone and Fortress).

The paper is available here: Get Ready for The Private Equity Shakeout by Heinrich Liechtenstein, Heino Meerkatt.