The Dangers of Private Equity Investing
The performance of private-equity (PE) funds has been disappointing. New research explains why this happened: Instead of driving operational efficiencies (as PE investors typically claim they do), those funds relied heavily on increasing the debt burden for the companies they bought.
Attracted by the glamour and potential for lottery-like returns, global private equity (PE) assets under management reached $4.2 trillion in 2022. PE involves pooling capital to invest in private companies either in the form of providing venture capital (VC) to startups or by taking over and restructuring mature firms via leveraged buyouts (LBOs). PE investors believe that the benefits outweigh the challenges not present in publicly traded assets – such as complexity of structure, capital calls (and the need to hold liquidity to meet them), illiquidity, higher betas than the market, high volatility of returns (the standard deviation of private equity is in excess of 100%), extreme skewness in returns (the median return of PE is much lower than the mean), lack of transparency and high costs. Other challenges for investors in direct PE investments include performance-reporting data, which suffer from self-report bias and biased NAVs, which understate the true variation in the value of PE investments.
Another important challenge for PE investors is understanding the drivers of returns. The PE industry touts its ability to create operational efficiencies in the companies they acquire, thereby increasing valuations. Is this fact or marketing hype? To attempt to answer that question, the research team at Verdad analyzed a sample from S&P’s Capital IQ of 993 PE deals from 1996 to 2021 in which both preacquisition and post-acquisition financials were publicly disclosed as a result of public-debt issuance. While 993 deals is admittedly a small sample of the total number of transactions (in the last decade, there were about 5,000 to 10,000 deals per year, while its database included only 16-105 deals per year), its data set captured a meaningful percentage of the largest deals: The average revenue of a company in the dataset was $760 million, average EBITDA was $96 million, and most of the big headline-making deals like Dell, Staples and Toys “R” Us were included.
To determine if PE acquirers created operational efficiencies or achieved gains due to changes in capital structure (increased use of leverage) – or some combination of both – Verdad analyzed six key metrics in the three years before and after the deal (buyout holding periods are about three years on average). They then compared their data to the aggregate metrics for public companies in the same sector in the same year. Following is a summary of their findings: