“Private equity” is the term for companies not publicly traded or “listed” (on stock exchanges). If you are like most investors, you don’t think much about private equity because it is not generally available to you as an investor. Many private equity businesses are local firms. While they are too small to be listed on stock exchanges, you might deal with them on a daily basis. Their owners are private, hence the term “private equity.” 

Some of the most visible private equity firms are Elon Musk’s Space X, Mars (makers of Snickers and M&Ms), Love’s Travel Stops, Fidelity Investments, and many thousands of others. You can’t buy any of their stock from a broker. There are roughly 6,000 publicly traded companies in the US per the Fasttrack database. Census.gov lists over 5,500,000 private companies. For every stock that is publicly traded, there are around 1,000 that are private. 

I’ve been concerned for years about the number of listed stocks shrinking as more and more of them are taken private, often by private equity funds such as hedge funds, endowments, etc. (or PE funds as I refer to them). Companies are often taken private by a combination of deep-pocket investor money and loans. These transactions differ from the family-owned Mars company, for instance, because Mars wants to keep customers happy by making the best products. PE funds, on the other hand, want to squeeze as much profit out of the company as possible in the short term so they can “flip” the company to another buyer at a higher valuation. If this short-term focus leads to longer-term problems, it doesn’t matter because the private equity fund expects to be long gone.

Two recent articles sent shivers down my spine about private equity. One was talking about celebrities getting into the private equity game, such as Tony Robbins and Kim Kardashian pitching their PE funds to small investors. On Oct 3rd, 2024, the Wall Street Journal published an article about Wall Street wanting to offer PE funds to individual investors.  This condition is almost as alarming as when Joe Kennedy got out of the stock market in early 1929 because his cab driver began spouting stock tips. Kennedy realized when the little investors were all into an investment, there were no more buyers left, only sellers. And running out of buyers is what makes markets tank.

When everyone from celebrities to rookies in sports to prestigious educational institutions starts touting private equity, the last buyers are being drawn in. 

My second shiver was caused by an article talking about the over-valuation of many private equity firms. Fueled by cheap money during the low-interest rate era we just came through, it was cheaper and less risky to buy companies with borrowed money than to start up a competing one. So hedge funds and PE funds were buying with both hands. Competition to find firms to buy became so intense that private equity firms began paying top dollar and looking at more marginal businesses, rolling into group investments many independent businesses like dentist offices, car washes, hospitals, laundromats, veterinarians, smoothie joints, restaurants, self-storage units, and funeral homes. PE funds have created a massive bubble in private equity values. 

Have you noticed that across wide swaths of our economy, the prices are higher and service is worse? This may be due to PE firms owning more and more of these businesses and being focused on profits over service quality. Newsletter writer Jared Dillon states that “private equity-owned nursing homes have a much higher mortality rate.” CBS News warns readers “Be Scared” after private equity spends $10 billion buying hospitals. We can see this problem these days in many industries. 

Many of these purchases were financed with loans of up to 70% of the purported value and this debt, much of it unregulated, creates shiver #3. 

If our economy softens and these private firms begin to struggle, those lenders might decide they want their money back from the funds that owe them. Remember, there is no market for these private companies, and to sell them might take fire sale prices and a lot of time. Think losses of half to two-thirds of invested money. The fact that holding periods are lengthening means that private equity firms are having trouble unloading their illiquid portfolios.

Private equity poses real, systemic risks to the economy, and this is primarily cash leveraged at 2, 3 or sometimes 10 times leverage. Many deals are done with 30% cash and 70% loans (2.33 X leverage). Debt is piled upon top of debt on top of debt and used to amplify returns.

And now, we are in a position where we depend upon private equity being a solid investment. Your pension depends upon it. University endowments depend upon it. Banks depend upon it. And unregulated, private lenders depend upon it. But PE funds underlying assets are illiquid, and if there is a real downturn, there is little they can do about unloading them. They are running out of buyers.

The price of money can be measured by interest rates. Banks and unregulated private lenders are up to their eyeballs in PE fund debt and they are already having to pay more and more to get new loans.

Failure to refinance this debt may be what pops the bubble as interest rates for these highly leveraged loans have nearly doubled recently. When this series of dominos starts to fall, we may have a sequel to the 2008 financial crisis.

As you can see from this chart, 88.6% of private debt needs refinancing in the next 5 years, and the increased cost of interest will destroy the profits of many of these firms. We are just entering this high-risk market environment, so buckle up.

All it takes for the private equity/debt bubble to pop is a catalyst. I can imagine a scenario during the next bear market in stocks when PE investors start asking hard questions of their funds and the redemption orders will start. Even if the PE firms can honor redemptions, they may be forced to sell underlying assets to fund redemptions at distressed levels, if they can sell them at all. Do you know anyone who has the cash to buy a distressed hospital? Or a carwash? Me neither. 

Much like the financial engineering that fueled the mortgage bubble that popped in 2008, we’ve hit what I think are peak levels in the private equity cycle. An unwinding of this bubble is imminent, in my opinion. I don’t know if it will happen right after the election, next year, or a bit later, but when something simply can’t continue, at some point it won’t. There are cracks showing in the PE market, and when investors rush for the exits, only the quickest will get out. 

We have already planned for this possibility in our investment strategies. If you are not yet a client, ask your adviser what they plan to do when the debt (bond) markets collapse. If they say “just hold and be patient,” you may want to reconsider your strategy. Let us know how we can help.