Next Financial Crisis: Private Equity

By: Sam Vaknin, Brussels Morning

What have we learned from the last banking and financial crisis a mere 15 years ago? Nothing it would seem. Another meltdown is brewing in full sight and no one is batting an eyelid, possibly because a lot of slush is greasing helpful political and regulatory wheels.

The culprit this time is known as private equity. It is managed in funds by financial advisory firms. The directors of these companies – and the firms themselves - invest about 1% of the capital of the funds and hurry to retrieve their “investment” via an assortment of exorbitant fees, charges, and commissions.

Pension funds and other institutional investors are on the hook for the remaining 99% of the capital. The money is ploughed into operating businesses, but this is where the similarity to the much more sober index funds ends.

While index funds buy incremental lots of stocks over many years or decades and diversify their portfolios, private equity funds take over entire targets, lock, stock, and often sinking barrel.

Worse still, private equity funds borrow huge dollops of money to complete these dubious transactions, known as LBOs (leveraged buyouts). This is why most of them are also dubbed “buyout funds”.

While index funds are heavily regulated, shockingly, private equity funds are subject to no regulatory oversight, however cursory. Private equity advisors operate under toothless and nebulous laws such as the Investment Advisers Act in the USA.

Like venture capital and hedge funds, private equity is a cornucopia of rapacious incentive fees, usually a 2-3% management fee, regardless of how dismal the performance is plus 20% of the profits, regardless of how fictitious these are. Such fees are illegal in all other parts of the money management and investment industry.

Moreover: index funds are obligated to provide daily liquidity by redeeming their shares. Private equity funds lock capital investments for many years with no clear or promulgated exit strategy, essentially a hostage-taking situation.

Most such funds have a theoretical termination date, an obligation to liquidate in 7-12 years. But this, too, is a mirage: they simply roll over the invested capital to newly formed private equity funds (secondary or continuation buyouts). In other circles, this would fit the bill of a Ponzi scheme. ?

Even worse: the very word “equity” is misleading in the context of private equity. The funds seek to offload their purchases in order to realize a profit and so are never long-term, truly committed investors. The median ownership time is 6 years. These funds actually resemble the pernicious “flippers” of Wall Street, albeit they flip their holdings more glacially.

The erstwhile exit strategies of an IPO (initial public offering) or through a sale to a public company are now rare. In effect, possession is cycled between private equity firms in kind of offshore shell game.

To believe the self-serving propaganda of these secretive firms and funds, they provide a valuable service: strategic and operational advice and an optimizing form of restructuring for a swathe of suboptimal businesses. They also afford favorable albeit somewhat incestuous access to the financial sector: banks, hedge funds, insurance companies, and other lenders.

But the truth is that most of these transactions are glorified forms of privileged insider trading. The new management is focused on enhancing the cash flow rather than on maximizing internal value, relations with stakeholders, and product or service quality. They invariably downsize brutally, axe capital investments, and cheapen product inputs.

Typically, a single firm runs multiple private equity funds in various stages of the funds’s life cycle. The implicit leverage is stratospheric and the funds cross-amplify it with their internal transactions. This is known, ominously, as a private equity complex.

The USA is always the harbinger of bad tidings such as asset bubbles. The private equity industry is no exception. About 35% of corporate equity in the States is now outside of public companies and, therefore, invisible and unregulated.

Worse still: the cancer of private equity is now metastasizing in Europe and throughout Asia and eating into more traditional pecuniary sectors and activities, such as broker-dealerships, real estate financing (including mortgages), and credit (lending).

In 2022, private equity funds in the USA alone raised 1 trillion USD and managed a whopping 12 trillion USD in assets. This is equal to 20% of total corporate equity or 5 times the ratio at the turn of this century, increasing by a compounded annual rate of 15%. The economy as a whole grew by a mere 3.6%, annually compounded. The discrepancy between these growth rates reflects, of course, leveraged debt.

The private equity industry is a nuclear timebomb primed to explode at any minute and take us all down with it. Such a conflagration will dwarf the disintegration of 2008-9. Yet, not a single politician or analyst is warning against these new excesses. Such deafening silence is enough to render one a conspiracy theorist.

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Sam Vaknin, Ph.D. is a former economic advisor to governments (Nigeria, Sierra Leone, North Macedonia), served as the editor in chief of “Global Politician” and as a columnist in various print and international media including “Central Europe Review” and United Press International (UPI). He taught psychology and finance in various academic institutions in several countries (https://www.narcissistic-abuse.com/cv.html )