The private equity boom experienced a sudden halt last year due to rising interest rates by the U.S. Federal Reserve. However, Bain & Company’s Global Private Equity Report remains optimistic about the industry’s future. While past market downturns have presented attractive buyout opportunities, the current landscape may be different. Private equity has historically thrived in an environment of easy money and lax regulation, which may not persist in the future.
The modern private equity industry took off in 1981 when former Treasury Secretary Bill Simon made a profitable acquisition of Gibson Greetings. This coincided with the start of the U.S. bond bull market, fueling the industry’s growth. After the financial crisis, the Fed’s zero interest rate policy made buyout financing even more appealing. Income-seeking investors eagerly invested in leveraged loans and low-yield junk bonds. Additionally, ultralow interest rates boosted stock market valuations, further enhancing returns for leveraged buyouts.
The popularity of private equity soared, with the industry’s assets under management increasing by nearly $10 trillion in the decade following 2012. Even during the pandemic, global private equity deals surpassed $1 trillion for the first time. Companies controlled by buyout firms leveraged low-cost borrowing to finance dividend payments, while private equity funds raised record amounts of capital, resulting in a significant “dry powder” of $3.7 trillion.
However, the music stopped in mid-2022 when the Fed began raising rates and banks grew more cautious about lending. The value of U.S. buyout deals in the last quarter of the year dropped by half compared to the previous year and has remained depressed since. While the current market downturn may offer bargains, there is now intense competition among private equity funds for limited opportunities. Moreover, financing conditions are unlikely to be as favorable as they were in recent years. Bond bear markets typically last for decades, potentially leading to higher borrowing costs, lower valuations, and reduced investment returns for private equity funds.
Another significant challenge facing the buyout industry is the potential tightening of regulations. Like bond market cycles, regulatory cycles can last for extended periods. The birth of private equity coincided with a relaxation of regulations and tax cuts during the Reagan administration. Private equity has been able to engage in industry rollups, consolidating various sectors through multiple acquisitions. However, critics argue that private equity contributes to inequality, company failures, worker mistreatment, and declining service quality.
Private equity is accused of favoring businesses with captive audiences and stable cash flows, which can support high leverage. Excessive debt often leads to bankruptcies, as seen in high-profile cases like Hertz and Toys R Us. Financial engineering practices, such as selling and leasing back real estate assets, generate quick profits but can leave firms struggling to meet rental payments during economic downturns. Private equity ownership has been linked to a significant number of U.S. retail failures. Critics even claim that the industry allows firms to fail to evade pension obligations.
According to these critics, private equity acts as an extractive institution, transferring income and wealth from one subset of society to another. They argue that private equity does not foster economic growth but rather destroys it. Moreover, private equity firms are believed to benefit from their political connections, with influential figures transitioning from government positions to the private equity industry.
While some of these claims are questionable, the criticism against private equity is growing. There is a rising lobby seeking to expose, litigate, regulate, and legislate against the industry’s perceived abuses. Regulatory bodies like the Department of Justice and the Federal Trade Commission are already adopting a tougher stance against anti-competitive mergers. Private equity may face challenges from both tighter financing conditions and increased regulatory scrutiny.