Institutional investors such as super and pension funds are investing in private equity at “exactly the wrong time,” a top hedge fund manager has warned, as sharply higher interest rates threaten a wave of bankruptcies.
Dan Rasmussen of Boston-based hedge fund Verdad said privately owned companies were more expensive to own than the broader S&P 500, based on transaction data, and the risks were compounded by “excessive leverage”.
Mr Rasmussen told the Sohn Hearts & Minds conference in Sydney on Friday that private-equity owned companies were typically backed by debt which accounted for more than half of their enterprise value.
But the sharp increase in borrowing costs – as their loans are tied to movements in broad-based interest rates – made them vulnerable to default.
“The majority of them are cashflow negative, and about 50 per cent of [earnings] for private companies in 2022 was going to interest payments as a result of spiking interest costs,” he said, adding that the figure would increase to 70 per cent this year.
“You’re looking at a very highly levered... high bankruptcy-risk type profile for the average private equity backed company... Yet that is the darling of institutional investors who are now taking up their allocations near 40 per cent in the private markets at exactly the worst time.”
Have to be in both
Some investors believe that private equity and venture capital present a compelling opportunity.
B Capital’s Sheila Patel, a former senior executive of Goldman Sachs Asset Management and co-chairman of venture fund Antler Capital, said declining valuations in venture capital were providing some enticing opportunities.
Data published by aggregator PitchBook showed that over 17 per cent of follow-on financing rounds were at valuations below their previous raisings, the highest level in a decade.
“That, to me is a good thing. That to me speaks opportunity, and a chance to fund the best companies with the best technology and innovation that we all want to see funded with capital, and that also can potentially drive some great returns,” she said.
But Ms Patel observed a shift in investor capital from private to public markets.
“You’ve got a backdrop globally and here in Australia of higher rates that will persist. It’s a difficult time, but it’s a difficult time in the public markets as well. And honestly, you need to be both.
“Only about 15 per cent of your viable opportunities out there are public markets, the rest of the companies in the world are private.”
Bridgewater’s Atul Lele said both private and public companies faced challenges because the favourable backdrop for corporations – in which wages and input costs declined and capital was cheap and abundant – was coming to an end.
“When we play the tape forward, all of those dynamics are shifting, we’re seeing a pro-corporate environment fade in a really meaningful way.”
Meanwhile, Wall Street legend Dan Loeb of Third Point Capital said his firm was launching a private credit strategy to take advantage of the environment when good companies needed refinancing.
“What we’re seeing is a massive amount of deleveraging. Every company that we follow is aggressively paying down debt with free cash flow,” Mr Loeb told the conference.
“Companies that used to be comfortable with four- to six-times debt-to-earnings ratios are now being punished at three times and are looking to get under two-times.
“That makes sense given that rates are much higher than they were. The opportunities will come, not from defaults but from companies that maybe had a little bit of a hiccup or have a need for restructuring, and for fresh capital.”
This article was originally posted by The Australian Financial Review here.
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