Dark Days For Private Equity?

The last twelve months have not been good to private equity: The combination of high interest rates and stagnant asset valuations has made private equity’s alchemy of using debt, reorganization, and lucrative tax breaks to make money much more difficult to pull off, and many players in the space have struggled to maintain their growth rates.

Sixteen private equity concerns declared bankruptcy in the first 2 ½ months of 2023, a pace that would result in the second highest number since the Great Recession. Orlando Bravo, the CEO of private equity concern Thomas Bravo, observed recently that the private companies that are for sale are few and far between, and the public companies that can be bought are mainly unprofitable and without a clear path to profitability.

Even the established players in the game are struggling: Last week the Carlyle Group announced that its first quarter revenues were down nearly 50 percent over its numbers a year earlier.

Private equity firms are also discovering that the days of juicy targets, ripe for restructuring, are no more, and they are hunting new targets with some desperation. It is very possible that the private equity market has reached an inflection point: After so many firms have earned such large yields over the years by going into traditional markets and wringing market efficiencies, it may simply be the case that there are no longer many affordable targets out there, and the pursuit of return has gotten a little more desperate. That chase has led more than one private equity concern into the crypto space, and after the implosion of FTX none of these survived unscathed.

These days it seems as if private equity has a target on its back. In the last week both the New York Times and National Public Radio (twice!) have laid out the case against its very business model. Former Times Business Reporter Gretchen Morgenstern—one of the most esteemed of the caste—has a book coming out later this month entitled These are the Plunderers that constitutes a devastating critique of the entire industry, essentially arguing that private equity investors create much less value to the economy than they take out of it. Bloomberg columnist Alison Schrager (a friend of mine) recently wrote that another pernicious result of private equity’s behavior is that public pension funds poured money into their funds in the last decade in an attempt to plug the gaping shortfalls they have, only to see PE’s struggles of late dig them a deeper hole.

If an increasingly populist GOP begins to embrace the notion that carried interest (which treats most of the income earned by private equity holders as capital gains for tax purposes) benefits almost no one but the one percenters who run private equity and that few of those in this cohort has any allegiance to the GOP, the left wing of the Democratic party may find a willing partner to reconsider this tax break once the main provisions of the 2017 Tax Cut and Jobs Act expire in 2025. Such a scenario would undoubtedly trigger a large debate over the progressivity and productivity of the current tax code and the friends of private equity may not be able to save them.

However, there remains a viable model for private equity that seems to be immune from the vicissitudes of interest rates or populist tax policy. Companies that focus on a narrow niche, and are prepared to make significant investments and spend a considerable amount of time identifying well-performing companies and helping them improve their performance seem to be able to make money in this new milieu.

One company that’s managed to navigate the dicey investment waters of late has been Vista Equity Partners, which is a private equity concern that invests in enterprise software companies and other technology startups. It currently has nearly $100 billion of assets under management, which makes it one of the biggest private equity players in the country. It is run by Robert Smith, who’s the wealthiest African—American in the country.

Smith has had an incredible run as an investor: Since the firm’s inception in 2000, Vista has returned a 2.84 times net multiple of invested capital and a 32.6% net internal rate of return across realized fund investments, according to an investor presentation viewed by The Wall Street Journal. What’s more, less than one percent of the companies Vista has purchased has gone under—a performance worthy of Warren Buffet. Vista has managed to navigate the exceptionally frothy software market multiples of the last several years – both selling into the public market highs of 2020 and subsequently shifting gears to subsequently acquire several companies once those values fell back to earth.

Warren Buffett famously remarked that when the tide goes out we discover who’s not wearing a bathing suit. For many in private equity the tide’s already receding.