A Perfect Storm
The Credit Strategist Blog
The private equity industry is facing a perfect storm. After enjoying the spoils of an undeserved Fed bailout during the pandemic, private equity is watching its riches vaporize. Even before private equity firms start disclosing problems in their highly leveraged PE and credit portfolios, their publicly traded stock prices are collapsing. From their 52-week highs, best-in-breed BX (down -39.74% from its 52-week high through the close of trading on June 17th), APO (-40.48%), ARES (-39.48%), KKR (-46.15%) and CG (-46.62%) are among the biggest non-tech losers in the current market meltdown (I don’t include TPG because it only went public recently and its stock doesn’t have enough trading history to evaluate yet). Price declines accelerated last week with their largest one-day losses since the Great Financial Crisis and pandemic with ~10% drops across the board on June 13th and further ~8% drawdowns two days later on June 16th. These same stocks tripled or quadrupled during the “pandemic rally” (I place that term in italics to emphasize its oxymoronicity) after the Fed’s ill-advised PE bailout which promoted financial speculation and irresponsible debt creation by, among other things, extending the lives of many zombie companies that damaged the economy through price cutting and other anti-competitive behavior. Private equity stock prices also rallied over the last two years despite companies converting from partnership to corporate structures after the Trump tax bill lowered corporate tax rates, effectively raising their taxes and lowering the after-tax earnings that reach their shareholders by subjecting their earnings to an additional layer of taxation. All of this left their inflated stock prices dangerously vulnerable when the Fed finally raised interest rates. In addition to raising the cost of their primary raw material (money), higher rates will force them to lower the valuations of their highly leveraged portfolio companies and lead to higher defaults in both their private equity and credit portfolios. And that will likely lead them to lower their rich dividend distributions which are among the most attractive attributes of these stocks. The industry’s stock performance reflects the fact that the current environment is the worst possible environment for an industry built on cheap money. These stocks could easily decline a further ~25% before bottoming out at which time they would start to look attractive based on the industry’s proven ability to recover from earlier downturns and the enormous amount of dry powder on which it should still be sitting when the smoke clears. But for now, the Fed is at best only halfway done raising rates and only began QT last week. Conditions will grow far more hostile for private equity before they improve. There will be far more attractive entry points for these stocks. No need to sit around and wait for things to improve.