Is PE existentially fucked?

Here comes a barely coherent rant:

I just don't see how the industry can generate the returns necessary to continue to charge high fees and raise increasing amounts of capital when you're doing deals at 12x EBITDA with 7x of debt with companies that have already gone through 3 buyout cycles. MM PE especially (call it $50-200MM checks) seems especially saturated at this point as every deal that isn't a total dog is priced to perfection in an auction process with 100+ prospective buyers. "Operational focus" is table stakes at this point and every reputable firm has some former GE six sigma black belt boomer that can "lean" out processes. Proprietary sourcing doesn't exist for any companies with decent scale worth buying. Distressed / turnaround is a) overcrowded; and b) like trying to catch a falling knife.

And despite all this you have mediocre funds raising BILLIONS of dollars in this environment. I wouldn't be surprised if top quartile IRR for 2016-2020 vintage funds is like 10%, which is absolute dogshit when you consider leverage and illiquidity but I guess you can't expect any better when it's the same guys trading the same portcos at increasingly inflated valuations. Is there any hope left in the industry? Any reason there won't be a major shake out in 10 years? The only thing I can think of is LPs continuing to flood the space with money and just accepting shitty returns because there's literally nowhere else for them to park their cash while attempting to make good on their bloated pension obligations. I guess the smarter ones have already come to that realization considering Calpers is planning to LEVERAGE THEIR WHOLE GODDAMN fund.

Comments (48)

  • Intern in IB-M&A
Jun 15, 2020

I really hope not lol. All these pessimistic posts about the future of IB/PE/VC are scaring me.

Funniest
  • Intern in IB-M&A
Jun 15, 2020

If that scares you S&T must give you flashbacks to Vietnam.

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Jun 17, 2020

Triggered me just now. The northerners would tease me with names like Pumpkin Bear.

  • Associate 2 in CorpDev
Jun 17, 2020

Man, interns nowadays are getting really funny lol

Jun 17, 2020

Finance overall is fucked bro

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Jun 15, 2020

We're seeing a convergence of private and public markets and I think fees will be included in that convergence. Days of 2 and 20 aren't gone but will be soon except for (maybe) truly consistently alpha-generating GPs. So while not existentially fucked, certainly the industry is currently unsustainable and will look very different in a decade or two.

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Jun 15, 2020

Just like any crowded asset class, eventually those running the same strategy as everyone else will face problems...

Disagree re: MM distressed/turnaround being crowded though. Look @ CSC/KKR Z-Gallerie & DirectBuy deal...

  • Analyst 2 in IB - Gen
Jun 15, 2020

Agree on that distressed/turnaround deal part but there are a dozen other funds betting on this strategy as well, which in turn will increase interest of other funds and will eventually drive up prices and diminishing returns..

PE is no longer an alternative asset class and it will eventually catch up with whats going on in the HF space. Only the best with both "capital' and 'expertise' will survive

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Jun 17, 2020

Do you think career in the Hedge Funds is worth it anymore? or simplier career paths in company finance roles, consulting are more attractive at this point?

Jun 15, 2020

distressed investing as a strategy is completely fucked imo. gone are the days of limited capital in the space, not only do you have distressed guys scrambling to MM and LMM (thereby crowding lower end of market) but also you have flexible capital funds (i.e. the Ares type buyout shops that can do distressed) and regulation that enables businesses to refi/get financing in tough situations. Most businesses that are left in general for distressed to control are straight garbage with limited upside. There will always be cases of good deals but they are pretty rare finds in the past several years

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Jun 15, 2020

I don't know about anything beyond LMM but there are tons of deals in eCommerce/DTC on the turnaround side of things. I've had good luck buying into distressed companies, then repackaging them as Series A/Series B ready and gradually flipping stock at VC valuations to growth equity guys after buying at distressed valuations. Look @ CSC Generation on the LMM/MM retailer/eCommerce side of things. Very unique strategy but they're doing extremely well without any issues.

Jun 15, 2020

I'm not sure how you can make the generalization that an entire industry has existential risk because it is mature and saturated. Is the apparel industry existentially screwed? Is the food industry? No, the PE industry will evolve and economic Darwinism will ensue. What you will most likely see is further capital consolidation around the most established PE firms or anyone who can propose a differentiated track record. If you think track records are all the same in PE, then you have not worked in the industry long enough to realize.

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Jun 15, 2020

If there were a finite number of acquisition targets in a PE timeline and the market wasn't cyclic, then your assumption re "12x EBITDA with 7x of debt with companies that have already gone through 3 buyout cycles" may hold true, but that's not the case in the real world... Also, 12x EBITDA is probably no longer the norm since that kind of multiple was seen more often during the height of the market (e.g. pre-covid).

Why does Calpers leveraging their fund have anything to do with them not putting their money into PE? Their CIO (Ben Meng) is a PE die-hard and has been lobbying for a while to allocate more capital to PE (and is continuing to do so).

Jun 15, 2020

CalPERS levering up their fund is an indictment on PE returns as a whole. The fact that a huge proponent of the industry feels the need to add leverage on top of leverage is pretty damning

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Jun 15, 2020

I didn't read the Calpers' news to mean that they were moving away from PE at all - just that they were trying to juice up their returns (I have a feeling they will be allocating even more capital to PE going forward). There are other PE investors (like fund of funds) that lever up when they invest into a PE fund. I guess it's unusual for a state pension plan to lever up this much, but Calpers is not your typical state pension and their CIO is also the more "adventurous" type, to put it nicely.

Jun 15, 2020

if you wanna see the future of PE, look at the past of hedge funds
very similar progression, but maybe a little more challenging to inflate cuz of Mark-to-market policies.

my take is the strong will survive and continue to do deals and pay well, just as the strong hedge funds have
but the weak ones will get drowned out

also, there will be another iteration of finance in our generation that people with relevant skills and experience will be able to take part in, which is the whole reason we go into this industry in the first place

Jun 15, 2020

Good point on hedge funds - the mark to market policy and easier redemption terms makes it very difficult to continue running hedge funds in difficult markets. PE is totally different in that they don't generally do mark to market (and have a lot of control over valuations of portfolio investments) and have much more restrictive redemption terms (although secondary markets have developed quite a bit and an LP are allowed to leave at times, as long as they can find an appropriate "replacement"). This PE "illiquidity" is even seen as a plus by some investors (e.g., illiquidity "discount" rather than "premium"), most notably Calpers' CIO.

Jun 15, 2020

"Existentially fucked" may have been hyperbole but my point is, PE isn't some mythical promised land anymore. The industry is becoming increasingly commoditized as the best funds "secret sauce" has become more public and diffuse around the industry. I'm sure funds will continue to raise capital but I can't imagine a world where PE (even top tier funds) have consistently outstanding returns when factoring in illiquidity, leverage, etc.

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Jun 15, 2020

Yes, PE is existentially fucked in the long-term (which might be 20-50 years or more). See below:

  1. Does Private Equity generate Alpha? - Here is how Eugene Fama, 2013 Economics Nobel Prize winner, would respond:

"We [...] emphasize that if private equity managers have skill in choosing good investment projects and bringing them to fruition, the result is a return due to the human capital of the private equity managers. Labor economists would argue that this return goes to the human capital, that is, the managers. Talented private equity managers are the scarce resource here, not investors' capital. As a result, the fees of managers should be set so that private equity investors just get expected returns that compensate them for the high risks of the investments."

"Finally, because the returns to private equity investments have large idiosyncratic random components (in addition to high market sensitivity), a wide range of outcomes is likely purely by chance. It is then predictable that the lucky managers are anointed by investors and the media, and they are flooded with new money from investors, even when past performance is due to luck."

Source: https://famafrench.dimensional.com/questions-answe...

  1. Historical Performance - "Our analysis suggests that private equity does not seem to offer as attractive a net-of-fee return edge over public market counterparts as it did 15-20 years ago, from either a historical or forward-looking perspective. Institutional interest in private equity has increased despite its mediocre performance in the past decade versus corresponding public markets, and weak evidence on the existence of an illiquidity premium. Although this demand may reflect a (possibly misplaced) conviction in the illiquidity premium, it may also be due to the appeal of the smoothed returns of illiquid assets in general."

Sources: https://www.aqr.com/Insights/Research/White-Papers..., https://www.aqr.com/Insights/Perspectives/The-Illi...

  1. Performance Persistence - "The conventional wisdom for investors in private equity funds is to invest in partnerships that have performed well in the past. This is based on the belief that performance in private equity persists across funds of the same partnership [...] Post-2000 we find little evidence for persistence in buyout funds, except for the lower-end of the performance distribution"

Sources: https://www.calpers.ca.gov/docs/board-agendas/2015..., https://pdfs.semanticscholar.org/3c31/135608cf8cbc...

  1. Ex-Ante choice of top-performing PE Firms - If you are betting on pre-identifying good funds to join, then take a look at David Swensen over at Yale. He has been unable to meaningfully outperform the Cambridge Associates average PE return for the past 20 years. For reference, Yale's 20 year historical return on its leveraged buyout investments is 12.1%, while the 20-year PE industry average return, during the same period, according to Cambridge Associates is ~12.32% (this could be survivorship bias, but still quite embarassing if you ask me). If Swensen cannot outperform the PE index despite probably having access to "top decile managers", then why do you believe you can pick a PE firm that will generate gargantuan returns without it being a statistical artifact?

Yale Returns: https://static1.squarespace.com/static/55db7b87e4b...

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Jun 15, 2020

Most of the studies that you cite seem pretty dated (e.g., the Fama "Q&A" that you reference is from 10 years ago). I'm not sure if this is sufficient to confidently declare that PE is "existentially fucked." Like some of the other posters noted, we expect to see capital consolidation around the more established PE firms, but not sure if we can say at this point that this industry is "existentially fucked" based on these dated studies.

Jun 15, 2020

Bro, the AQR papers are 2019, the Yale returns are 2018, and the Calpers study is 2014...

Fama's point is a theoretical one - being dated isn't particularly relevant... Pretty basic human capital theory.

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Jun 17, 2020

This forum is so predictable. While I'm not sure I agree with the phrase "existentially fucked," you provided actual evidence in good faith that let some of the air out of the over inflated balloon that is PE, and you were drowned in monkey shit for it. I suppose it's hard not to take a post like this as a personal affront if you have more or less based your entire professional life on getting into PE, but just because the evidence he presented doesn't agree with your worldview, it doesn't mean it's wrong. This is just confirmation bias at its finest folks. Contrarian viewpoints are important, and unfortunately for many on this forum, I'm not sure that this one will be contrarian for much longer.

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  • Intern in IB - Gen
Jun 15, 2020

If PE is fucked then what is the best post-banking career for someone who loves investing? Also, are you sure PE is actually fucked? I though it has higher returns than any asset class ... would also think values will be depressed in the near-term, so the 5-10 yr outlook could be favorable, no?

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Jun 15, 2020

Please don't make any career decisions based on the weekly 'PE/HF/VC is fucked' post lol

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  • Analyst 1 in IB - Gen
Jun 19, 2020

This applies to every single industry witch hunt shitpost on this site. Finance is never going to "die", headcount might reduce and talent will commensurately flow elsewhere. Sub areas of finance might become more efficient and better equipped with better technological tools enabling people to work smarter - like, no shit, that's fucking capitalism.

But "die"? Come the fuck on. Are people not going to be participating into the global capital markets anymore? Will businesses not seek alternative ownership? Who the fuck sets prices and keeps public companies accountable if not active investors?

I'm honestly getting really sick of these wolf cryers shitting on one of the most critical components of the global economy (that will continue to serve as an attractive, highly compensated and interesting career regardless of structural changes) so non-chalantly. Go back to guessing the next world crisis or something, christ.

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  • Analyst 1 in CorpFin
Jun 19, 2020

Once you remove leverage, isn't PE really achieving below average returns?

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Most Helpful
Jun 15, 2020

I think you're conflating three different questions -

i. Will PE returns decline?
ii. Will PE funds continue to exist?
iii. Will PE professionals continue to make out-sized salaries / bonuses?

The answer to all 3 is yes.

PE returns will inevitably decline - that's what happens when there is more competition for the same product (alpha). But consider this - can you find higher returns in an asset class that has dozens of bidders and one in which there is massive, cheap leverage available relative to an asset class that has millions of bidders and is way too volatile / expensive to lever up (stock market?). Probably yes. All that is a long way of saying - PE returns will come down - but it'll still likely, on average, be higher than equity returns (and forget about fixed income). Long-story short - it's still the best place to put money to get a bang for your buck.

There will be a consolidation of GPs as LPs favor "one stop shops" and top quartile funds.

Lastly, compensation. Just think about the private equity business model and you'll realize compensation will remain elevated for a long time to come. Can you name a single other business / business model where all that is required to make many multiples of profit on billions of dollars of investments is a few dozen employees and (maybe) renting an office somewhere? I frankly can't - and unlike hedge funds, the capital is locked up for years.

A mid-level PE professional can very, very conceivably retire into a "normal job" (e.g. teaching high school) after one ~4-5 year stint with UMM/MF fund. There are not many other salaried jobs where the risk/reward outcome is skewed as it is here.

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Jun 16, 2020

Nailed it. The only thing that matters it the willingness of pensions, endowments, countries, family offices, wealthy individuals, etc to give money to PE. Returns don't matter. PE still keeps getting money. Look at energy.

Close the fund, lock the money up, make a bunch of investments, milk the fees for 5-10 years, hope 1 or 2 deals are home runs, the rest are probably dogs, post a below average but not disastrous return, raise next fund and repeat.

It is just an incredible business model but literally only exists as long as people still giving them money, and they do.

Jun 16, 2020
Texas Tea:

Nailed it. The only thing that matters it the willingness of pensions, endowments, countries, family offices, wealthy individuals, etc to give money to PE. Returns don't matter. PE still keeps getting money. Look at energy.

Close the fund, lock the money up, make a bunch of investments, milk the fees for 5-10 years, hope 1 or 2 deals are home runs, the rest are probably dogs, post a below average but not disastrous return, raise next fund and repeat.

It is just an incredible business model but literally only exists as long as people still giving them money, and they do.

You just described venture capital... in theory PE should be more about hitting doubles and triples and the odd home run (not a grand slam of course) with a few goose eggs or losses to average things out. But I totally agree with your main point on locked up fees.

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Jun 16, 2020

My impression is that ppl are still willing to throw money at PE (regardless of all the studies cited in above posts) because PE is really good at self-branding and also has a lot of control over their "performance" (e.g., somewhat controversial manipulation of IRR by using subscription facility, although subscription facility is at times used for legit business reasons) and valuation of their portfolio, given that there is very limited info on private investments (this, and your point on lock-up, is what distinguish the PE business model from HFs). Also, investment managers at pensions, endowments, family offices and etc. are often compensated based on the "performance" of their underlying PE investments - so there is less of an incentive for these managers to dig deep into the performance metrics to get at the real numbers so long as they are happy with whatever performance record that the underlying PE guys are touting.

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Jun 16, 2020

Having spoken to multiple large LPs - I think a crucial differentiator between say, a L/S hedge fund and PE is that PE can very clearly and convincingly articulate a reason for outperformance over time. What do I mean?

Case A - L/S Hedge Fund

In a L/S hedge fund, at the end of the day you're job is to basically identify mis-priced securities. In a market that is at least somewhat efficient, combined with the information edge diminishing every single day and a market with millions of participants - the ability to identify mis-priced assets consistently is exceptionally rare. Warren Buffett thinks that maybe - maybe - there is a single handful of people on Earth that can do this.

Case B - Private Equity

Unlike hedge funds, the path to making money doesn't really require anyone to identify mis-priced assets. What it does require is both the vision and the capabilities to improve the underlying operations of a business. Compared to identifying mis-priced assets, effecting operational changes is easier - and importantly, for an LP, it is conceptually much easier to grasp. Trimming costs, implementing actual financial controls, being smart about marketing, product development, sourcing and M&A - there are many growth drivers that can be acted upon (opportunity, of course diminishes over time as as asset is flipped by multiple sponsors).

Moreover, PE firms typically identify assets that are inherently somewhat more stable than your average business - this, combined with their relationships, allow them to significantly enhance returns through leverage - which creates meaningful equity value for the LPs. This last point can't be over-emphasized- many times I've heard "we'll - they (PE firms) are just juicing returns w/ leverage". Yes - PE firms are. But two identical businesses - one backed by a blue-chip PE sponsor, and one without will have very, very different abilities to put leverage and the interest rates charged will be vastly different as well. This ability to source cheap financing is a source of value creation itself for the LP that is only accessible through PE.

Love it or hate it - fair or not - Private Equity firms have an incredible business model.

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Jun 16, 2020

'08 & COVID have put a huge amount of unexpected capital into the market. The effects of '08 are still seen today in inflated equity prices and low interest / savings rates. There is basically nowhere to put your money to get a return (eg. savings rates at your typical retail bank in the 70s/80s was like 8%). I'm guessing that all this COVID printing that the Fed is doing will only make these things worse.

What does this mean for PE?
- With so much more money in the market and everyone looking for attractive returns, the PE space will become more competitive and returns will go down due to this competitiveness & all the extra dollars in play (+ so many funds look at MOIC so they will be willing to sacrifice basis points on yield if they can show an investor that they'll actually put their money to use. Howard Marks has a good memo on this: MOIC v IRR).
- Salaries/wages/bonuses will remain high because there will be so much more money in the space. Incentive packages & fee structures might be reworked, but the PE guys will always make sure to take their cut first.
- PE as a strategy isn't going anywhere. Where else are you going to put your money?
- PE as an industry will consolidate to a degree. With so much money competing for the same deals, buying up other PE firms will be an easier way to "grow" your business, esp when you can't win deals.
- The PE firms of the future will probably become 2 types (my guess): one stop shops or ultra specialists. You either have a board that has done every type of deal under the sun, or you have a shop that only does 1 type of deal in 1 industry, at one size, and they've been doing it for years.

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Jun 16, 2020

Locked up money? PE yes HF no
Real mark to market? PE no HF yes
Fake mark to market? PE yes HF no

BRILLIANT business model. Just be good at branding and fundraising.

Disclosure: I hate PE and you'll never find me interviewing or working at a traditional PE firm. BUT I can put that bias aside and acknowledge that it is probably the best and most risk averse way for someone to make really really good money.

Jun 18, 2020

Just going to address one particular element of the original poster's argument (the EBITDA multiple). I agree that leading up to COVID, multiples were the highest they've ever been. But my answer is: "This doesn't impact returns the way everyone seems to think it does."

You've got to remember, PE firms are both buyers and sellers. If a PE firm is buying at 12x they are also selling at 12x. If debt/equity levels are maintained, this alone doesn't actually have a really huge impact on the returns. But it does have a really important implication for the SOURCE of returns.

Back in the day when companies traded for much lower multiples, the relative impact of cash flow was higher. For every $1 of cash flow generated by the company, this resulted in $1 of additional equity value for the shareholders. When buying/selling a company for 5x, this basically meant that five years of cash flow generated the same amount of equity as the sale of the company (using EBITDA as a proxy for cash flow for simplification).

So fast forward to today. The same level of EBITDA still generates the same amount of equity value ($1 of EBITDA = $1 of equity value). However, now that multiples have expanded and the same company trades for 12x instead of 5x, it now takes 12 years for the cash flow to equal the exit value. Compound this with the fact that more debt is being placed on the business and cash flow is no longer a significant driver of returns.

What does this mean? Historically, growing EBITDA by $1 meant an extra $5 at exit, but now it means $12 at exit! All of a sudden cash flow is not nearly as important as EBITDA growth. PE firms therefore need to focus their efforts on growing earnings rather than financial structuring. This is one of the many reasons you've seen such a proliferation of "operationally focused PE firms."

So while I agree with your description of the market (high multiples, more saturated, etc.), I don't think that the result is a collapse of the industry. As long as PE firms remain both buyers and sellers, they are partially insulated from significant changes to multiples over the long term. The ones who tend to lose due to this dynamic are the investors that buy assets and never sell (such as Berkshire Hathaway).

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Jun 18, 2020

Good response, mate. You're last paragraph is spot on.

Seem like most do not fully understand the words "private equity" - an over simplification of a segment of the capital markets industry which contains a wide variety of financial instrument creators.

I come here when I'm bored....
Jun 18, 2020

Economics 101 dictates that over the long run, above-market returns (at least on a risk-adjusted basis) cannot exist. If a firm is generating above-market profits, supply will increase until those profits shrink to 0 (accounting for risk and opportunity cost). In the short term, barriers to entry and other sources of friction can preserve profits, but in the long run, those barriers ultimately erode.

Private equity is no exception to that rule, but neither is any other industry. You are not entitled to ever make above-market returns and if you have the opportunity to do so in the short run, you should be grateful and get what you can get while the going is good. And in the long run, never get complacent and perpetually be on the lookout for new opportunities and keep investing in yourself so you can avoid becoming obsolete as the markets do their thing. Change is the world's only constant.

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Jun 18, 2020

humblebot, I disagree. I don't think this is an appropriate application of that economic principle. That principle applies very well when you have a good or service that is easily replicated (and thus others can enter the market and increase supply). Private Equity is not so easily replicated. Yes, anyone can set up a private equity firm, but that does not mean they have replicated the service. In addition, Private Equity firms can innovate through things such as the moment towards operational expertise as discussed above. They can also adjust strategies, identify new opportunities for investment, and do a bunch of other things to continue to generate above-market returns.

Now, I understand that you said "in the long run" ... which could mean 30-50+ years. If that's what you meant, I'll just say that i don't think that is applicable for the types of discussions on these forums given most people here should be retired in 30+ years!

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  • Analyst 1 in IB-M&A
Jun 18, 2020

Great comment. I think a more pronounced example is VC. Anybody can start a VC fund, but they can't replicate the connections/access to funding rounds that the top VC funds can, which in turn leads to many funds having shit returns while others are doing great.

Jun 22, 2020
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Jun 19, 2020
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