(Photo by Rickharp) (CC BY) (Resized/Cropped)

(Photo by Rickharp) (CC BY) (Resized/Cropped)

Dear colleagues,

If you had to guess, who would you say was the most rankled by these two words uttered by Federal Reserve Chair Janet Yellen recently: “greater gradualism?” Though insurance companies and banks certainly were among those most agitated, Illinois lawmakers are sure to have topped the list. With the judiciary’s recent rebuke, it’s clear there will be no reforms, meaning Chicago’s pension will run dry in the next decade. It’s no shock that Fitch, the credit rating agency, acted swiftly to downgrade Chicago’s municipal rating.

The Windy City is far from being alone. Pensions, more than any other constituency, are caught in the double crosshairs of the seemingly perpetually low interest rate environment. Not only are their liabilities magnified — their obligations, after all, are simply the present-day discounted value of their future obligations. But insult is added to injury with every day rates remain at their lows as liabilities grow as a factor of time because there’s less assumed discounting on future benefit payments.

But it doesn’t end there. A pension’s performance is married at the hip to its rate of return assumption; if the stated mark is missed, which at last check was north of 7%, a way must be found to make up for the deficiency. Increasingly this has pushed pensions into private equity investments which promise to outperform the conventional stock and bond markets, in exchange, of course, for pricey illiquidity and risk premiums.

That makes private equity’s prospects the least discussed issue on the campaign trail considering how blatantly angry voters are. Just imagine how infuriated pensioners will be when they discover that those safeguarding their retirements were forced to fire-sale their most liquid investments into cratering markets because their other assets were locked down in private equity funds.

The linked piece below today’s post is a follow-up to last year’s private equity primer. It’s difficult to fathom a way out for pensions. Your thoughts on the subject, as always, are most welcome.



The Smell of Dryer Powder in the Morning

It takes a certain, shall we say a more stalwart, kind of a person to willingly endure a second showing of certain movies some find unsettling. Deliverance, The Silence of the Lambs and Taxi Driver all come to mind. So too does Apocalypse Now, one of the most stunning cinematographic accomplishments of the 20th Century but also one of the most disturbing. Thus the renewed “Horror!” when Francis Ford Coppola endeavored to remake this classic for the 21st Century, and in the process 49 additional minutes for fans’ viewing pleasure.

But something, perhaps to critics’ surprise, rose from the cutting room floor. An even better film emerged. In the words of legendary film connoisseur Roger Ebert, it was “more clear than ever that Francis Ford Coppola’s ‘Apocalypse Now’ is one of the great films of all time.” The majesty of Redux stemmed from Coppola and his longtime editor Walter Murch’s approach to the new version. They conceived the May 2011 movie from scratch, using the original dailies, as if the first movie had never been made.

There is now another possible 21st Century remake on another cutting room floor, the trading floor, that is. With this potential remake comes a question that no doubt haunts today’s investors: Are the markets capable of producing an equally miraculous encore? Determining markets’ fate largely comes down to their overlords, the kingpins of private equity. At its most simplistic, a central bank is considered to be the lender of last resort, if circumstances should force that outcome. The mirror image is private equity and the role it can play as buyer of last resort when cycles are nearing their denouement.

It’s safe to say that the chronological moment of truth is upon us as April crosses the line in the sand making the current stock market rally the second longest in history, trailing only that which crescendoed in March of 2000. Last year at this time, the list of rally-rousers was appreciably longer. Sovereign wealth funds were not in liquidation mode defending their countries’ fiscal well-being. The initial public offering market was still wide open for business. Unicorn funding was still making believers out of California dreamers. And central bankers’ actions held sway over animal spirits for longer than a few trading days.

But those halcyon days have come and gone leaving in their wake sidelined skeptics at just about every turn, including private equity insiders faced with a forecast that calls for a perfect economic storm. There is, however, one mammoth impediment to private equity joining other would-be buyers who are now in self-imposed holding patterns: money, and lots of it.

In private equity parlance, this ‘money’ is actually capital their investors, known as limited partners (LPs), have committed to invest through funds that have been raised. Those in the business refer to it as ‘dry powder,’ as in readily deployable weaponry to wage war on the acquisition front.

A fresh off the press report by the global consultancy Bain & Co details the year ahead for the private equity industry. The comprehensive study first looks back to 2015, which would have been one for the record books if not for its predecessor.

For starters, 2015 marked the fifth consecutive year that cash distributions from private equity funds to their LPs eclipsed capital calls (cash infusions) LPs had to cough up for fresh investments. Among LPs, fewer than 10 percent had wired in funds in excess of what they had allocated for the calendar year, the lowest since 2007. While this imbalance is great from a cash flow perspective, it also highlights the challenge overvalued assets present to private equity firms that are in the business of buying assets of every kind from public companies, to real estate, to venture capital.

At the core of the hostile buying environment is the Federal Reserve. Private equity has traditionally been largely in control of its own destiny, especially in the buyout arena. You know the legends of leveraged buyouts (LBOs); the takeover of RJR Nabisco was so renowned for its hostility it merited infamy in its own book and movie, Barbarians at the Gate. But that was so ‘80s.

More recently, we have Clear Channel, Harrah’s and TXU as LBO reference points. Some of the vestiges of these deals are still, in fact, with us today though the sensation evoked at the mention of these names is indigestion not elation, also care of the Fed.

How so? Bear in mind, the Fed was also private equity’s BFF early on in the aftermath of the Great Crisis. Exits that would never have been possible in the real world were rendered so with the magic of zero interest rates. After all, why restructure when you can refinance into a junk bond market that never had it so good? Such was the mantra in the world of private equity. That is, until rates were left too low for longer than even the barbarians could bear.

By the beginning of last year, buyout funds found themselves ponying up record sums based on multiples of a target’s earnings before interest, taxes, depreciation and amortization (EBITDA). At 10.1 times EBITDA, 2015 multiples trumped even those of 2007’s 9.7 times.

It’s safe to say few ever anticipated the bawdiest buyout time in Wall Street history to ever be taken out, especially given LBO volumes. At $282 billion last year, global buyouts were only a hair above that of 2014 and deal count actually fell. Peak valuations suggest that deal volumes should also be running at record levels but in fact, the last two years haven’t witnessed even half the activity of record years 2006 and 2007.

And yet, at over $4 trillion, mergers & acquisition (M&A) activity did dethrone 2007’s former peak. That’s the funny thing about ill-conceived monetary policy. The unintended consequences show up in the least likely places, like the M&A battlefield. Corporations, which have been decreasingly rewarded for buying back their own shares, are still reluctant to invest in their businesses. (The Fed, more than seven years in, has yet to wake up to this reality. But the fact remains companies will simply not make major investments until they know how to envision a clean operating environment, an impossibility with artificially low interest rates.)

The alternative to share buybacks to juice your earnings: Buy other companies to grow the top line in the absence of economic growth that justifies organically growing the company, and payrolls, from the inside out. And that’s exactly what companies have been doing with their inflated stock prices and cheap debt financing. The nasty side effect for private equity firms is that corporations have literally priced themselves out of their own LBO market.

As the Bain report dryly concludes:

“With generally benign debt markets continuing to finance most deals, this confluence of favorable conditions has created attractive industry economics for every constituency save one: current buyers.”

What’s a private equity chieftain to do? Well that is the trillion-dollar question weighing on just about every professional investor’s mind. You see, at $1.3 trillion, they’re sitting on $100 billion more than they were at this time last year. That’s what happens when you’re taking in more in capital commitments than you’re shelling out to make fresh investments for five years running.

That said, 2015’s fundraising of $527 billion did not surpass 2014’s $555 billion, nor did it come close to the $681 billion record raised in 2008. But the figure was nevertheless extraordinary against a backdrop of anemic global growth and cratering commodities prices.

2015’s slightly lower level of fundraising also masks the fact that the year did not put an end to one of the biggest road trips of all time. No fewer than 12 large buyout funds, each of which was targeting funds of $5 billion or more — that’s $86 billion in aggregate — were still on the road at the beginning of this year. And that’s just the big boys. In all, some 318 global buyout funds were road-showing at year end, seeking to raise $247 billion, the largest dollar figure since 2008 and the highest number of funds in the market at one time on record.

The main driver: insatiable demand on the part of those ravenous limited partners, which the Bain report characterized as “hungrier than ever.” Bain might have added that LPs are in a hurry: Private equity funds require lock-ups of a decade or more in some cases and tend to take about a year to raise a given fund. That makes it more remarkable yet that 40 percent of buyout funds closed in six months or less.

As the Bain report noted:

“Funds are closing faster, and the share of those that hit or exceeded their goals was higher in 2015 than at any time since the precrisis boom of 2007.”

Not surprisingly, LPs are also particularly keen on the biggest names with proven track records. Among the five largest funds closed in 2015, all exceeded their fundraising targets and every one was significantly larger than its predecessor. The biggest of the bunch was Blackstone Capital Partners VII, which raised $18 billion, the second-biggest since that record year, 2008. Launched in November 2014, the fund closed before the holiday season with committed capital at 111 percent of its predecessor fund, as in BCP VI.

Odds are high that LPs appetites won’t wane any time soon. You may have noted in recent headlines that efforts to right Chicago’s pension plan were ruled unconstitutional by the judiciary, prompting Fitch to downgrade the city’s credit rating to one mere notch above junk status.

In the event you’re not connecting the dots, pensions, tethered as they are to unrealistic rate of return assumptions, will remain beholden to private equity investments until such time as they’re allowed to revert to prudent portfolio allocations. That, however, won’t happen until the time comes to truly reform the pension system, which might never happen if the courts stand their ground.

The sad thing, for retirees whose pensions will run dry if something doesn’t give, is that higher interest rates could have prevented this gigantic mess in the first place. But the decline in interest rates has been relentless and has yet to let up. The ultimate Catch 22: the lower interest rates fell, the further pension managers had to swing for the fences to make up for the shortfall. Hence pensions’ record and reckless allocations to private equity funds, which are egregiously inappropriate given their risk profile and pensions’ inherent liquidity requirements as Baby Boomers begin to retire en masse.

Of course, all may turn out well if private equity firms somehow manage to thread the needle, a feat that requires them to deploy committed capital and not pay up for overpriced assets even as recession looms and threatens their ability to execute deals in the junk bond market.

Just keeping the high yield market open for business is a tall order. Even if the current cycle takes out the one that crashed to a halt in 2000, it would take a miracle of monetary policy to get all the junk debt coming due refinanced.

According to Moody’s, U.S. junk-rated companies have $947 billion of debt maturing between 2016 and 2020. The furious rate at which high yield firms have been accessing the capital markets is best illustrated by the fact that five-year maturities have risen by a fifth from Moody’s February 2015 report and 18 percent from the previous high of $805 billion recorded in 2010.

The coming deluge of junk-debt refinancing helps explain why the last of the big three credit rating agencies, Standard & Poor’s (S&P), recently reported the average rating on high yield issuers had fallen to a record low. As sure as day follows night, S&P warns, defaults promise to chase crippled credit quality into the sunset.

So what is private equity to do? As buyer of last resort, does the industry have a moral obligation to keep the fires burning under the current historic rally? Most will hope so. But the risk grows with every mega-fund raised that the perverse investing environment will render private equity’s record pile of dry powder into something akin to napalm. Can you say Apocalypse Then?


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