WORKERS CAPITAL VS VULTURE FUNDS

The £5 trillion ‘pyramid scheme’ threatening to wreck your retirement

Ben Marlow
Fri, 24 November 2023 

Pyramid Scheme

The collapse of Southland Royalty, a private equity-backed oil-and-gas explorer that owned fields in Wyoming’s Green River basin and New Mexico’s San Juan Basin, in early 2020, was unremarkable in many ways.

On the one hand, it was merely the latest shale driller to fall victim to a double-whammy of a near-halving of oil prices from highs of nearly $100 (£80) a barrel in the middle of 2014, together with a four-year low in gas prices.

It faced other headwinds too. Recent drilling results had been disappointing and the company’s banks had cut its borrowing facilities. In a downturn that was sweeping through America’s shale industry, Southland was the 43rd bankruptcy in 12 brutal months.

Yet to others, Southland was more than just another casualty of the boom and bust of the energy sector’s latest gold rush.

As recently as the September before Southland went bust, its owners, an $18bn Houston-based buyout firm called EnCap, had valued its slice of the business at nearly $780m – almost the same amount as it had ploughed into Southland up until that point.

Yet, by the end of the year, EnCap had written down the investment to zero. Weeks later, Southland collapsed – an extraordinary example of value destruction even by the notoriously go-go standards of private equity.

Critics of the industry say the fate of Southland and hundreds of others like it, is indicative of a dangerous mismatch between over-inflated paper valuations of buyout-backed companies and their true worth – a discrepancy that its most fierce detractors insist has become more pronounced as a decade of record low interest rates has come screeching to a halt.

What’s more, they say, it is an imbalance that could have potentially devastating consequences for millions of people’s retirement savings pots as pension funds funnel even greater pools of capital into private equity funds at artificial prices.

“Eventually all these funds filter back to someone’s pension fund,” one City adviser says.

Jeff Hooke, a former investment banker-turned-academic at the Johns Hopkins Carey Business School in Washington DC, describes the way in which private equity values its investments as “the Wild West”.

“Maybe it was okay 15 years ago – you could say it was a niche part of the financial markets, a very narrow part of institutional portfolios, and the regulators could say we have bigger fish to fry. But in some cases, the big state pension plans have 25pc to 30pc of their assets sitting in these alternative investment vehicles.”

Such concerns are increasingly shared by regulators and policymakers. In the UK, the Financial Conduct Authority (FCA) has begun what has been described as “a sweeping review” into valuations of the whole spectrum of private assets from private equity and venture capital, to commercial property and hedge funds.

Its investigation has been prompted by growing fears over the impact of a sharp reversal in interest rates.

Nikhil Rathi, chief of the FCA, which is investigating valuations of private assets - Eddie Mulholland

“The macro economy has moved from a period of low interest rates for a very lengthy period of time, and markets are now expecting . . . higher interest rates for longer,” the watchdog’s chief Nikhil Rathi said last month. “At some point, you might expect that risk will crystallise in valuations of assets.”

His comments were interpreted in some quarters as a warning to auditors that their work with private equity is under the spotlight.

It is understood the Bank of England has given its full backing to the FCA’s interrogation, having warned repeatedly of the risks from stresses in the private equity market, as well as the even more opaque private credit arena.

In its March Financial Stability Report, the Financial Policy Committee (FPC) expressed fears that “illiquidity and infrequent re-pricing of private credit assets created uncertainty…and might expose investors to sharp revaluations and losses”.

Then in July, the FPC cautioned that “riskier corporate borrowing in financial markets – such as private credit and leveraged lending – appeared particularly vulnerable.”

“Signs of stress in the leveraged loan market…due to a worsening macroeconomic outlook, could cause a rapid reassessment of risks by investors, potentially resulting in sharp revaluations and fire sales,” it went on.

The International Organization of Securities Commissions (IOSCO) has similarly warned of “hidden risks” in private markets from the sharp spike in rates.

“When you combine that kind of vulnerability with a lack of transparency, and a changing macro-financial environment, you have a cause for concern,” IOSCO chair Jean-Paul Servais told the Financial Times. Servais is also concerned about market complacency. “There is…a little too much confidence that all will be fine,” he said.

Rock bottom interest rates were a double boon for the private equity industry: the borrowing that underpins its model became cheaper than ever; and institutional investors, seeking higher yields, poured money into buyout firms promising both generous and less volatile returns than the stock market.

Calpers, the biggest public pension fund in America, plans to up its allocation to private equity from 8pc to 13pc of its nearly $450bn of assets under management.

BT’s pension fund, which is among the largest corporate retirement plans in Britain, has sunk a growing proportion of its investments in more illiquid, privately-held assets, as its exposure to equities has rapidly shrunk. It has £1.1bn of £38bn of assets in private equity and a further nearly £9bn in property, credit, and infrastructure.

Even smaller investors have become converts to private equity. The Scott Trust, the owner of The Guardian, allocated nothing to private investments in 2015. Its most recent disclosures show a quarter of its £1.2bn endowment backing buyouts.

As part of reforms unveiled in the Chancellor’s Autumn Statement, managers of the Local Government Pension Scheme (LGPS) have been asked to more than double its allocation to private equity, from less than 5pc to 10pc, to help boost economic growth. The LGPS, which is administered by 86 town hall pension funds, oversees £360bn of assets.

Prior to the pandemic, the high watermark for Wall Street’s buyout barons was the deal boom of 2006 and 2007 that immediately preceded the financial crisis. Fuelled by dirt-cheap and plentiful credit, private equity embarked on an astonishing shopping spree – in many instances teaming up in club deals to go after targets previously considered to be out of reach.

More than a decade and a half later, the ten biggest private equity takeovers in history contain seven from that dizzying period.

Yet, it was nothing compared to the frenzy that was unleashed during the chaos of Covid as stock prices collapsed and central banks slashed interest rates to an all-time low in a desperate attempt to prop up the global economy.

In 2021 alone, more than 1,500 British companies – many of them household names – vanished into private hands including supermarket chain Morrisons, defence supplier Ultra Electronics, and security giant G4S.

Private equity chalked up $1.3tr worth of deals worldwide – shattering the previous high of $670bn set in the year before Lehman Brothers imploded.

Lots were snapped up at bombed out prices and are therefore more likely to have held their value. However, thousands of others bought during more benign times when stock prices were high and debt was both abundant and cheap are likely to be worth significantly less now the music has suddenly stopped.

Yet this isn’t properly reflected in the figures that the industry has reported, Hooke says.

“In 2022, when the US stock market dropped 20pc, the private equity industry said their holdings fell 0pc, which defies rationality. It also defies all financial theory about the value of private assets versus public assets.”

There isn’t a major industry where buyout funds haven’t made inroads. Globally, the private equity industry controls assets worth more than $6tn, according to a McKinsey report published earlier this year.

But it’s the so-called “leveraged buyouts” (LBO), where the balance sheets of the companies that are being bought are loaded with large debts to fund their own takeover, that are most vulnerable to wild swings in value.

In the US, there are around 700 LBO funds, controlling more than 7,000 companies and with roughly $1tr of equity invested. They make up an estimated two thirds of the American private equity market.

It is these that are likely to be the most overvalued, Hooke believes. “In 2008, the American stock market dropped something like 35pc and private equity – principally LBOs – only fell 20pc. That’s just laughable.”

He estimates that in the case of a 31pc fall in the public markets, the value of highly-leveraged private companies should tumble as much as 67pc because of “the magnifying effect of leverage on equity returns”.

The chief concern is that when it comes to valuing the companies they own, private equity is effectively allowed to mark its own homework. A spokesman for the British Private Equity & Venture Capital Association says: “Private capital firms deliver robust valuations to ensure global institutions can invest confidently in the asset class.

“The methodologies and processes underpinning valuations are subject to regulation and annual external audits, follow relevant accounting standards, and are undertaken at a frequency to meet the demands of investors.”

Yet, it is more art than science. Owners are required to hold assets at “fair value” under accounting rules. The practice is known as “mark to market” but is often derided as “mark-to-myth” because mostly, private equity firms decide how to value their investments and when to change those valuations, in contrast with the real-time valuations provided by the stock market.

A paper produced by Hooke and economist Eileen Appelbaum of the Centre for Economic and Policy Research describes these as little more than “guesstimates”.

They point out that unsold companies are illiquid assets, which means their “true value won’t be known until they are sold”. Worse, they are likely to be “optimistically high” because the fund managers that 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. Yet, it is not uncommon at the very biggest funds for as much as half of their investments to still be unsold even after more than a decade.

“The question then becomes, if the fund’s underlying investments are valuable, how come no one wants to buy them after so many years?” Hooke asks.

Appelbaum points to a seemingly never-ending procession of failed stock market floats from private equity owners as further evidence of overzealous valuations. Some have been so disastrous that private equity firms are resorting to buying back companies they only recently took public.

Some major investors are starting to ask questions too. Vincent Mortier, chief investment officer of French fund giant Amundi, with close to €2 trillion of assets, has compared parts of the buyout world to “a pyramid scheme” because of “circular” deals in which companies are sold between private owners at high valuations. “Just because there’s no mark to market doesn’t mean there’s no risk,” Mortier says.

This weekend Mortier told The Telegraph he had not intended to imply fraud.

But he says: “True value is known with certainty only when there are exits through IPO or sale to non-private equity owners.”

His counterpart at the Wellcome Trust, Nick Moakes, recently warned of a “shakeout” in private equity that could result in painful losses for investors who piled into the sector without properly understanding the risks of holding illiquid assets.

Moakes calls it “tourist capital” – people who have invested in assets with “inappropriate risk profiles for them”. With £38bn under management, the Wellcome Trust is one of the world’s largest charitable foundations.

America’s financial policeman is attempting to impose tough new rules on private equity, the property sector and hedge funds. In what would be one of the toughest clampdowns in its history, the US Securities and Exchange Commission (SEC) argues that its reforms, including detailed quarterly performance reports, will provide better protection for investors.

Gary Gensler, boss of America’s financial policeman the SEC, faced a barrage of opposition to financial reforms - Ting Shen/Bloomberg

SEC boss Gary Gensler has expressed concerns about transparency and the potential for financial stability risks but his efforts have run into fierce opposition after a powerful coalition of fund management trade bodies launched a lawsuit to block the rule changes, accusing it of “a vast power grab”.

Hooke says it’s “hard for the man on the street to comprehend” but ultimately any correction ends one of three ways with retirement benefits being cut, taxes going up, or employees having to pay more into their pension to make up the shortfall.

There are fears that a series of increasingly popular tactics are delaying private equity’s “price discovery” moment even further.

The use of “continuation funds” where a fund effectively sells a company to itself has come under particular scrutiny. They mask “an unpleasant truth”, Appelbaum says, by enabling the private equity firms to keep doing deals that shelter their companies from valuations in the public markets.

Mikkel Svenstrup, chief investment officer at the Danish pension giant ATP, has compared the practice to “a pyramid scheme”.

Mortier says: “Marked-to-market valuations are less reliable since these are often based on management forecasts, and the availability of continuation funds to extend the life of an investment asset – all these have the potential to delay the uncovering of problems.”

With the public markets perceived effectively closed for new share issues after a series of disastrous listings, and mergers and acquisitions activity subdued, the tendency will be to hold on to investments even longer.

Yet, in the case of the most financially-stretched companies, that will often depend on whether they can persuade their lenders to give them more time to repay their loans. Restructuring advisers call it “amend and extend” or “kicking the can down the road”.

But as one puts it: “It’s kicking the can down the road with the biggest boot and down the longest road ever. It’s in no one’s interest to fiddle with any of this.”