Will Private Equity Continue With the Amazing Returns?

I think rather than answer yes or no to your question, it makes more sense to examine some of the structural peculiarities that have emerged in the past decade, and what this means for Private Equity.

In my mind, the situation today is the product of mainly four forces which are acting in tandem: (1) The post-crisis regulation of traditional lending institutions, (2) prolonged periods of low interest rates as part of QE, (3) institutonal investors, and (4) the tech economy.

Let's start with (2). As I'm sure you know, the world has been more awash in capital than ever before in the past decade due to the cheapness of credit, thanks to QE. In my view, this has resulted in a few things:

• Investors who, in other times, would maintain a more even-handed composition of stocks and bonds in their portfolio are chasing returns by being more heavily invested in the equities markets. This is saturating the markets for public equities, pushing valuations to all-time highs. With rate increases looming, investors are ironically less inclined to swing back to bonds despite equity markets being so highly valued.

• I would argue that as the proverbial lifeboats fill up in the public markets, hedge funds and other actors that make money in those public markets will see their profitability suffer. This has been happening, and while inflows have increased, the industry is consolidating. Between PE and HF, PE is seen as the better bet nowadays, and I think it has something to do with how crowded the playing field is for HFs.

Moving on - let's examine (4). Unlike previous market eras, there is something remarkable happening currently to tech. The advent of AI, but more significantly, the revolution that is occurring in the field of data analysis is going to be like a second industrial revolution. Rightly so, investors coming out of their fallout shelters after '08 began to flock to the tech giants we have today, because these companies are actually producing staggeringly profitable new enterprises based upon revolutionary technology. The issue now, in light of my points above on (2), is that tech is a bubble within a bubble - that is to say, not only are investors crowding the equity markets, but they are crowding the equity markets for tech, largely because tech is cannibalizing the other sectors - look at what is happening to grocers, automobile manufacturers, retailers, etc., and the way that these age old forms of business are being co-opted by Amazon et al.

So, we have a lot of retail level investors cramming themselves into one compartment of one part of the economy. Why does this matter for PE?

This brings us to (3). I would argue that institutional investors nowadays, facing overly crowded equity markets, have increasingly turned to PE, and to a lesser degree HF, as these managers have historically been regarded as able to outperform the market with their expertise. PE assets have hit an all-time high this year, with the largest PE fund in history having been raised this past summer. This is exacerbated by the fact that many of these institutional investors are state pension plans, which are beginning to wake up to the reality that they are on the hook for grossly more pension payouts than their returns can sustain. Their response has been to funnel even more resources to the biggest names in PE/HF to try to eke out higher percentages in the face of pressure from the politicians that monitor their quarterly reports.

Before going on, want to note that I think the subject of retirement is a whole issue unto itself. If you want to read more on that, I did a more thorough write-up here.

So, PE and HF have become crowded as well by dint of their being the last refuge for huge players that can't seem to find enough space outside of private markets. I would argue that the huge amount of private capital out there right now, mixed with the general attitude that tech is the only sector worth investing in, has produced increasingly dubious investments from PE. Think of Theranos, Snapchat, and any number of other businesses that run the gamut from unprofitable to fraudulent, yet have at some point (or currently) sustained "unicorn" status of $1bn+ valuations. I would argue that there are several engines out there in the economy right now that are running on borrowed fuel - hemorrhaging money from quarter to quarter, and sustaining themselves with sucessive rounds of equity financing from managers that are desperately trying to find the next source of double digit returns. I cannot help but wonder at what point the managers' investors will need to see profitability. Perhaps it will be when they get greedy. Perhaps it will be when the staggering number of boomers without savings start to retire and need pension checks to cash.

Finally, I want to touch on (1). Since '08, many forms of riskier, middle market lending have been curtailed by the post-crisis regulations forced on the newly minted bank holding companies. The role of commercial banks on the fringes of the credit market has therefore been largely assumed by PE managers engaging in forms of direct lending that I would argue they are not experienced in. These are people whose bread and butter is buying companies, and now they're foraying into the business of writing loans as well. Aside from the fact that this is not their domain of expertise, these entities are also not banks. They are not huge entities with a global presence and a balance sheet to fall back on. They are restricted by fairly complex and rigid agreements with their limited partners. In other words, I don't think they are prepared to weather a downturn in their investments the same way that a bank might be able to.

Getting back to the question at hand - will PE continue to show amazing returns? I'd wager that their returns will still probably outstrip the market. But more interesting to me is the question of what the effects will be in the coming downturn of PE's dramatically larger presence in a weirdly concentrated economy, performing services that are historically out of their wheelhouse.