Why Private Equity Firms Won’t Stop Dancing
In 2010, after returning cash to investors and struggling to find a buyer, Candover – one of Europe’s largest private equity firms – went into liquidation. This was due to a series of failed investments amid the height of the frenzied private equity activity in 2007/08 and the company, once seen as the gold standard of European private equity, liquidated.
Today, the private equity industry is showing signs that it is in a perilously similar condition to 2007; a condition which previously resulted in an imminent collapse.
But first, what is private equity investment? It is, simply put, giving money to a firm, who pools money together from different investors into a ‘fund’ and then uses this fund to improve and develop private companies. As the companies in which they have invested begin to grow and develop, you (the investor) earn a return on your initial investment, while you pay the firm a fee for their services.
The warning signs in the private equity market are there for all to see and have been for a while. Private equity firms have been receiving record amounts of money from investors who are desperate to earn a return. This has allowed firms to raise record-sized funds: last summer, a US firm ‘Apollo Global Management’ opened a $25bn fund, the largest ever private equity fund raised. The European record was also broken in 2017 with a €16bn fund being raised 1. Not only are private equity firms being given more and more money to invest, they are being given it quicker than ever. While normally a firm may spend around a year speaking to potential investors trying to convince them to invest money, they are now only spending around 9 months doing so – highlighting the surge in demand for their services.
But surely more money and more demand in a financial market is a good thing? Not always. Given that private equity firms have record amounts of money to invest, they are under serious pressure to invest that money into profitable companies and earn the investors a return. Just think – if you gave someone money who promised to earn you a profit before returning it to you, you would want to see them actively working to earn that return, wouldn’t you?
Well, that isn’t quite happening just now. While plenty of money is undoubtedly being invested, private equity firms currently have more uninvested money on their books than they have ever had before. This money, known as ‘dry powder’, essentially gathers dust while it waits to be invested. Too much dry powder is bad for business; nobody invests money and pays a professional investment manager lofty fees to watch it gather dust. After all, uninvested money won’t earn a return, defeating the purpose of the initial investment.
The reason so much money is being left uninvested is simply put:, competition. Today, there are over 3,000 private equity firms in the UK and over 7,000 in the US. As mentioned, they are all receiving record amounts of money from investors in record times. Moreover, they are all looking for profitable companies to invest that money in. However, not all companies meet their criteria, and not all necessarily want a private equity firm investing in them (since private equity firms often have a large say in the day-to-day running of the business). As a result, there is intense competition between a huge number of private equity firms for a finite amount of profitable investment opportunities which has resulted in a lot of money being left on the shelf.
The laws of supply and demand in economics tell us that when we have so many buyers and only a finite amount of items to sell (private, profitable companies, in this case), rising demand causes the price of those goods to rise. Likewise, as there is a high demand and competition for companies in the private equity market private equity firms are currently paying more for their assets (companies) than they were in 2007/08, before the market eventually collapsed. And wide-scale overpricing (commonly referred to as a bubble) is rarely a good thing in any financial market.
All of this leads to a major concern: sloppy investments. If a private equity firm comes under serious pressure to invest money, there is a good chance that it may decide to invest in a company that it wouldn’t have touched under normal circumstances. This can potentially have a dangerous impact on the economy. If money is being invested in an unprofitable company that is in a weak financial position, it may ultimately default on its debt, leading to redundancies or liquidations – in short, the investment will go badly wrong. It may seem far-fetched, but this can become problematic, particularly if a large number of investments start to go wrong at the same time.
This problem was in part fuelled by low interest rates over the last few years (interest rates were reduced to help stimulate the economy after the global financial crisis). When interest rates are low, investors find it harder to earn a large return on traditional financial instruments, so they push more money into alternative investments, such as private equity. What’s more, this low interest rate environment makes bank loans cheaper, allowing private equity firms to take on record amounts of debt and make larger transactions than ever before. In any area of finance, more debt translates into more risk. As was the case in 2007, increasing risk and pressure due to inflated prices can lead to dangerously rash investments.
In the age of ever-advancing financial technology, investment vehicles – such as hedge funds and mutual funds – are now turning to machine learning and artificial intelligence (AI) to aid in selecting the most profitable investments. Essentially, algorithms select where to invest money, as opposed to a human researching different opportunities and selecting one. In 2016, the hedge fund industry recorded its sixth year-on-year increase in investors in quantitative funds – funds which depend on advanced algorithmic software to make investment selections – many of which depend on machine learning and AI 2. The private equity industry is lagging behind in this respect. Nevertheless, some leading Asian private equity firms are turning to AI in a bid to improve their investment screening process 3. In particular, they are using algorithms to filter through hundreds of companies’ financial data and accounts, in order to quickly select those which meet their initial investment criteria 4.
Despite the increased efficiency and profitability they can bring, technologies can have severe adverse effects on financial markets. We need only to remind ourselves of the 2010 ‘flash crash’, where the whole of the US stock market was inaccessible for over half an hour (a painfully long time for traders) and the market collapsed in a matter of seconds before quickly rebounding, causing huge widespread losses. As it happened, advanced computer-driven algorithms caused prices of stocks to plummet inside a few seconds, and panic in global markets ensued. While technology can undoubtedly have benefits to the financial industry, it can bring with it unprecedented dangers.
What should private equity firms do? Could advanced technologies like AI and machine-learning be the future of private equity investing? It remains to be seen whether the industry will embrace these advances to the same extent as other financial markets. What’s important to know now is this: private equity firms are taking on more risk and paying more for assets now than they have ever previously done, due to the intense pressure they face from investors. This increases the likelihood of sloppy investments. Altogether, these ought to be alarming signs. Only a decade ago, many private equity firms went bust after a period of similarly frenzied activity. In the meantime, it would make sense for firms to take on less money from investors and reduce their dry powder (money waiting to be invested). This would relieve some of the pressure on them to find profitable companies to invest in. Unfortunately, regardless of the financial market in which they operate, saying ‘no’ to more money as an investment manager is easier said than done. Memories can be short in financial markets; they simply keep on dancing while the music is playing.
This article was specialist edited by Chirsty McFadyen and copy-edited by Katrina Wesencraft.