“Private equity has absolutely no reason to exist. The private equity holder has all the upside and the banks all the downside.”
— Nassim Taleb
Nassim’s quote here isn’t entirely true though — is it? PE absolutely has a reason to exist: Since the GFC of 2008/2009, investors seemed to have had enough with the volatile nature of liquid (i.e. public) markets. Many were caught with their draws down (get it?), and that wasn’t consistent with their stated objectives and long-term investment vision — namely to generate above-average risk-adjusted returns over decades.
It seems the institutions of the world weren’t ready to deal with paradigm changes, shifting geopolitical climates, a turn from a value orientation towards growth investing etc.
Because of all this, and with the simple excuse (?) that “PE always overperforms all other asset classes” — they started moving more into PE investments.
And so, the rise and rise of Private Equity had begun.
We can see from Preqin data above that AuM in PE strategies not only continued to move up but actually accelerated. But does all this massive growth not come with a cost?
Market Distortions
In the early days of PE, the predominant strategy was the LBO. A PE sponsor would agree on an acquisition target, raise a thin equity stack and borrow to the hilt to execute the Leveraged Buy Out (LBO). For me, the most iconic LBO was the one where KKR bought RJR Nabisco, you can watch the movie “Barbarians At The Gate” if you want to know more.
That deal basically marked the turn of PE from a nichey, exotic and non-mainstream asset class — to a generally accepted strategy. Note that KKR used 87% leverage for that deal, today leverage ratios on buyouts are running at half that!
In the olden days PE was the alternative — it was the deal that came out of nowhere to create value for the brave few that had allocated to the strategy. With good leverage, opportunistic price multiples and intelligent value creation it created massive value for its investors.
Nowadays PE is the market — and this is why it’s getting exponentially harder to gain an edge and overperform.
Too much money chasing too few returns…