In 2021 alone, more than 1,500 British companies – many of them household names – disappeared into private hands, including supermarket chain Morrisons, defense supplier Ultra Electronics and security giant G4S.
Private equity recorded $1.3 trillion in transactions worldwide, surpassing the previous high of $670 billion set in the year before Lehman Brothers collapsed.
Properties were auctioned at inflated prices and therefore probably retained their value. However, thousands of others bought in more favorable times, when stock prices were high and debt was both plentiful and cheap, may be worth significantly less now that the music has suddenly stopped.
But this is not accurately reflected in the figures reported by the industry, says Hooke.
“In 2022, when the US stock market fell 20 percent, the private equity industry said its holdings fell 0 percent, defying all rationality. It also contradicts every financial theory about the value of private assets compared to public assets.”
There is no major industry in which buyout funds have not found their way. The private equity industry controls more than $6 trillion in assets worldwide, according to a McKinsey report released earlier this year.
However, the most susceptible to sharp fluctuations in value are the so-called “leveraged buyouts” (LBO), in which the balance sheets of the acquired companies are burdened with high levels of debt to finance their own takeover.
There are around 700 LBO funds in the US that control more than 7,000 companies and have around $1 trillion invested. They make up an estimated two-thirds of the American private equity market.
These are likely to be the most overvalued, Hooke believes. “In 2008, the American stock market fell about 35 percent and private equity – mainly LBOs – only fell 20 percent. This is just ridiculous.”
He estimates that in the event of a 31 percent decline in public markets, the value of highly leveraged private companies could fall by as much as 67 percent because “leverage magnifies stock returns.”
The main concern is that private equity is effectively allowed to do its own homework when valuing the companies it owns. A spokesperson for the British Private Equity & Venture Capital Association said: “Private capital firms provide robust valuations to ensure global institutions can invest in the asset class with confidence.”
“The methods and processes underlying the valuations are subject to regulation and annual external audits, follow relevant accounting standards and are carried out at a frequency consistent with investor requirements.”
Still, it’s more art than science. Accounting rules require owners to hold assets at “fair value.” The practice is known as “mark-to-market” but is often derided as “mark-to-myth” because private equity firms mostly decide how to value their investments and when to make them, as opposed to the real-time valuations provided Valuations change through the stock market.
In a paper prepared by Hooke and economist Eileen Appelbaum of the Center for Economic and Policy Research, these are described as little more than “estimates.”
They point out that unsold companies are illiquid assets, meaning their “true value will not be known until they are sold.” Worse, they are likely to be “optimistically high” because the fund managers who set the prices have “little incentive to reassess their value.”
Private equity houses typically buy a company with the intention of selling it within three to five years. Nevertheless, it is not uncommon for the very largest funds to still have up to half of their investments unsold even after more than a decade.
“The question then becomes: If the fund’s underlying investments are valuable, why doesn’t anyone want to buy them after so many years?” Hooke asks.
As further evidence of overzealous valuations, Appelbaum points to a seemingly endless series of failed IPOs by private equity owners. Some have been so disastrous that private equity firms have resorted to buying back companies they had recently taken public.
Some major investors are also starting to ask questions. Vincent Mortier, chief investment officer of French fund giant Amundi, which has nearly €2 trillion in assets, has likened parts of the buyout world to a “pyramid scheme” because of “circular” deals in which companies sell at high prices between private owners will be reviews. “Just because there is no mark-to-market does not mean there is no risk,” says Mortier.
This weekend, Mortier told The Telegraph he had no intention of suggesting fraud.
But he says, “The true value is only known with certainty when exits occur through initial public offerings or sales to non-private equity owners.”
His counterpart at Wellcome Trust, Nick Moakes, recently warned of a “cleanup” in the private equity space that could lead to painful losses for investors who rushed into the sector without fully understanding the risks of holding illiquid assets.
Moakes calls it “tourist capital” – people who have invested in assets with “risk profiles that are inappropriate for them.” With assets under management of £38 billion, the Wellcome Trust is one of the world’s largest charitable foundations.
America’s financial policeman is trying to impose tough new rules on private equity, real estate and hedge funds. The U.S. Securities and Exchange Commission (SEC) argues that its reforms, including detailed quarterly performance reports, would provide better protection for investors, which would be among the toughest measures in its history.
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