The private equity (PE) industry has been all the rage over the past 10 years.

Why? Interest rates.

Despite approaching 3% briefly in 2018, the US 10-year treasury has hovered around 2% since 2013.

However, that’s changing—and with that comes a change in the fortunes of the leveraged buyout (LBO) industry.

There are three “inputs” to make the sausage of an LBO:

1. The target or the deal

2. The price

3. The financing

Right now, there are plenty of deals to be had—that’s all well and good—and prices aren’t crazy high either.

But therein lies a problem in the third ingredient: financing.

You Need the Appetite

I’ve written quite a bit about 2023 bank failures. Silicon Valley Bank, Signature Bank, and First Republic are a handful that comes to mind.

We’ve also seen a few larger banks sell assets to shore up their balance sheets. PacWest Bancorp (PACW) just announced the sale of a bunch of real estate loans to opportunistic real estate firm Kennedy-Wilson Holdings (KW). More of this is coming…

When one bank fails, the whole industry starts to get spooked. Everyone looks around to guess who might be next.

Does that fear give them the confidence to fund highly leveraged LBO transactions? Of course not.

With financing, you need the appetite. And my sense is that banks today do not have it. Even those that do require a high-interest rate on any loans they make. And the financing ingredient requires the appetite and a reasonable interest rate.

What I’m hearing from my contacts in private equity and in the investment banking world is that even the Tier 1 private equity firms—KKR, Blackstone, Apollo, etc.—are still looking at 12%–15% (!) interest rates on their LBO loans.

That’s a remarkable range. Only a year ago, rates were dramatically lower.

So, the LBO market, due to the missing third ingredient, is struggling… and will continue to struggle.

How might this play out in the rest of the market?

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Enter CalPERS

I’ve written about the California Public Employees’ Retirement System (CalPERS) and its pettiness before. The agency, which manages the largest public pension fund in the US, went after Warren Buffett over something trivial, despite the fund having a palatial campus in Sacramento (among other gaffes).

Anyway, private equity has had a hell of a run. Again, my view is that it’s been driven by low rates and plenty of available financing.

In its infinite wisdom, CalPERS decided to increase its allocation to private equity.

As early as January 2023, the $469 billion pension fund announced it was increasing its allocation to private equity from 8% to 13%. On its asset base, that’s a $23 billion increase in cash going toward private equity.

This is classic “top ticking” behavior… but that’s CalPERS for you.

How This Shakes Out

The CalPERS data point is an interesting one. But here’s how it’ll shake out for public market investors…

To get an LBO done, you need all three ingredients: deals, price, and financing.

Nearly all LBO funds are fixed-life. That means investors give them money, and in 10 years, the PE fund promises to return it in cash—not stock or some other instrument.

Well, how can an LBO fund get out of a deal if its new buyer can’t get financing?

This is the problem: To exit its investments, it likely must adjust its price downward for the financing to work.

Lower price = lower return.

If it can’t exit, there’s always bankruptcy. And those are starting to ramp up as well…

Envision Healthcare was taken private by private equity giant KKR in 2018 for $5.5 billion. Just two weeks ago, the company filed for bankruptcy, wiping out billions in equity value for the private equity firm.

And Envision won’t be the last of the PE firms to go belly up.

What to Make of Tier 1 PE Firms

The Tier 1 private equity firms are all publicly traded: KKR & Co. (KKR), Blackstone (BX), and Apollo Global Management (APO). Now TPG (TPG) is buying another giant, Angelo Gordon, in an all-stock deal.

They each have their own spin on things, as well as their own strategies. Many of them eat their own cooking, meaning they (and not their investors such as CalPERS) own a piece of every deal. That’s somewhat comforting.

But my sense here is that returns won’t be as strong on their investments going forward. And their older funds will show poor returns as they sell their portfolio companies for much lower valuations than they originally expected.

The publicly traded PE firms might get cheap. But for now, I’m not a buyer.

Thanks for reading,

—Thompson Clark
Editor, Smart Money Monday

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