Private equity’s secret sauce is drying up

As banks are exhausted from funding billion-dollar buyouts and pension funds grow impatient with the never-ending thirst for capital from private equity, skepticism is growing about the industry’s performance – and whether some of their daredevil deals could result in disastrous losses for their financiers.

The mood on Wall Street is rapidly deteriorating. Companies such as Bank of America Corp., Credit Suisse Group AG and Goldman Sachs Group Inc. suffer more than $600 million in losses in a single transaction: the $16.5 billion leveraged buyout of the giant cloud computing Citrix Systems Inc. in January. Borrowing costs have since risen. Banks ended up selling $4 billion worth of Citrix-secured bonds at just 83.6 cents on the dollar, splattering red ink on their own balance sheets.

Already, one of the biggest lenders is backing down. Citigroup Inc. will reduce its exposure to so-called underwriting lines of credit, or short-term loans to private fund managers who use their investors’ capital commitment as collateral, to $20 billion from about $65 billion , reported the Financial Times.

For banks, underwriting lines are safe but low-margin, primarily used to cultivate relationships with private equity for more lucrative business, such as M&A fees. But for private equity fund managers, this form of borrowing has become unavoidable. This allows them to complete transactions without having to knock on their investors’ doors every time they need cash. After all, no one wants to be a nag, especially when money is tight.

But just as important, subscription lines can increase a fund’s internal rate of return, a key performance metric that private equity managers use to raise new money. In effect, this line of credit delays capital calls and shortens investors’ holding periods, thereby increasing paper returns.

It is perhaps no coincidence that the performance of private equity has been exceptional in recent years. Funds tend to draw on subscription lines early in their life. With record fundraising, the sector average may well be boosted by young funds exploiting this type of credit. But what is the true return on capital once that rug is pulled?

As borrowing costs soar — Citrix’s $4 billion bond was sold at a 10% yield last week — and stocks enter bearish territory, investors look to yields cash. By this measure, the performance of private equity is far from outstanding. Between 2020 and 2021, private equity funds received $4.9 trillion in contributions from their investors but only distributed $5.1 trillion, according to data provided by PitchBook.

In other words, the cumulative cash return was a pitiful 5.3% for the 12-year period.

To make matters worse, as public listings enter a dry spell, private equity funds are increasingly selling their investments to each other – often at big profits. For example, in August Vista Equity Partners LLC cashed out its stake in Ping Identity Holding Corp., which it acquired in 2016 for about $600 million, to fellow private equity firm Thoma Bravo LLC. The $2.8 billion deal valued the identity technology company 63% above market price.

Over the past two years, U.S. private equity firms have split their exit options primarily in three ways: IPOs, corporate acquisitions, or sales to other private equity firms, according to PitchBook. But in the first half of this year, more than half of the outflows were in the form of private equity sales to each other. “It’s not a bargain. It’s the start, potentially, of a pyramid scheme,” Mikkel Svenstrup, chief investment officer of Danish pension fund ATP, a major committed private equity investor, told the FT. in 147 buyout funds.

During the pandemic, a private equity boom has fattened many pockets and, on paper, boosted pension and endowment fund returns. But as we approach a global recession, return on capital is losing importance in favor of return on capital. A fundraising magnet, private equity has a more uneven track record when it comes to payouts. Meanwhile, some of the debt that accompanies its leveraged buyouts is far riskier than Citrix’s 10% bond. Who will stay with this bag?

More from Bloomberg Opinion:

• Hedge funds deserve to be beaten by private equity: Shuli Ren

• Matt Levine’s Money Stuff: Buyout loans have a bad week

• HSBC, Citigroup and the end of the World Bank: Marc Rubinstein

This column does not necessarily reflect the opinion of the Editorial Board or of Bloomberg LP and its owners.

Shuli Ren is a Bloomberg Opinion columnist covering Asian markets. A former investment banker, she was a markets reporter for Barron’s. She holds the CFA charter.

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