The $3 Trillion Private Equity Bubble is Finally Bursting

There's been a lot of talk about how the U.S. real estate market is in a bubble, but people are getting it wrong. The real bubble is in a little corner of the finance industry that is unknown to the average person. This industry has trillions of dollars in assets, and the companies it owns employ roughly 12 million Americans. The industry I'm talking about is private equity. So in this video, we're going to cover how this bubble in private equity formed, when it could burst, and most importantly, what this means for the economy. Now, let's get into the video.

Private equity has long been considered the gilded class of high finance. Its big bets and ginormous paydays are the envy of Wall Street. Private equity firms such as Blackstone, KKR, and Carlyle are considered some of the most prestigious companies in the entire world. Even relatively junior employees at these funds can see their pay approach half a million dollars annually, with senior investors regularly taking home seven-figure paydays. Yet, for all their savvy deal-making, even the titans of private equity are getting caught off guard by the swift rise in interest rates. Higher interest rates are causing companies owned by private equity billions of dollars in higher interest payments and threaten to push many of the portfolio companies into bankruptcy, the consequences of which would be devastating to investors, the economy, and the millions of people employed by these companies.

Before we dive deeper into what exactly is happening, we first have to understand the private equity business model at a fundamental level. The business model of a private equity firm is pretty darn simple. Let's say in this example we have a private equity fund named ABC Partners. Before ABC Partners can make any investments, the company has to have money to invest in the first place. Our firm here has a goal of investing 10 billion dollars.

Now, while private equity has been proven to be an incredibly lucrative industry, ABC Partners and its employees don't just have a spare 10 billion sitting around. Instead, and this is an important distinction, the money private equity firms invest is almost exclusively from investors outside the firm. The private equity firm would honestly prefer to not invest any of its own money, and you'll see why in a second. In our example here, ABC Partners gets the money to invest through what is referred to as fundraising. Employees of the firm go around to companies, organizations, and wealthy individuals, asking if they want to invest. Investors include insurance companies, pensions, university endowments, charities, and ultra-rich individuals and families.

Now, as I'm sure you already know, ABC Partners is not going to invest the money they raise for free. ABC Partners is a business in its own right, and they want to make money. So, in exchange for investing the money, ABC Partners is going to take a cut of the profits in the form of fees. There are many different types of fee arrangements out there, but for the purpose of this example, let's say ABC Partners is getting a 30% cut of all investment profits the firm generates.

Now that ABC Partners was able to get the money it needed for its fund from investors, it can now start investing. Private equity firms specialize in what is referred to as a leveraged buyout, or LBO for short. An LBO is a financial transaction where a company is purchased using a significant amount of borrowed money, a.k.a. debt. The idea behind an LBO is to use the cash the company being bought generates in the form of profits to pay off the debt gradually over time. A simple analogy is that an LBO is almost like an individual buying a rental property. When someone buys a rental property, they may put 20% of the price of the house down in cash and then borrow the remaining 80 percent from a bank. The owner of the property then uses the rent it generates to pay the bank back slowly over time. After enough time has passed, the owner of the property will have successfully paid back the bank and now owns the property outright.

The issue with the private equity business model is that it incentivizes and encourages private equity firms to use as much debt as humanly possible. Let me show you what I mean. Here we have two private equity firms, Firm A and Firm B. Both have one million dollars to invest in this example. Instead of using businesses, we are going to use houses to more easily demonstrate my point. To use round numbers, each house in our example here costs one million dollars. Firm A decides to take its one million dollars and buy five houses. This means that each house is purchased using 200,000 in cash from the firm and another 800,000 in the form of debt. The 200,000 from the private equity firm and the additional 800,000 in debt funds the one million dollar purchase price.

Let's say that after a few years, the value of these properties has increased twenty percent to 1.2 million dollars. Firm A decides to sell. Firm A takes the 1.2 million dollars per house and pays back the 800,000 dollars in debt it used to make the purchase. Firm A is left with 400,000 dollars for each of the five houses, or two million in total. We can see that Firm A was able to turn the one million into two million, a return of one hundred percent. Notice how even though the value of the assets that Firm A acquired, or the houses, increased in value by only 20 percent, Firm A was able to generate a 100% return by using debt.

Since private equity firms get a cut of the profits they generate, it's easy to see why they love using leverage. Let's take things up a notch. Let's say Firm B wanted to see how far they could push things. Instead of buying five houses like Firm A, Firm B decided to buy ten of them. That means instead of putting down two hundred thousand dollars per house, Firm B is putting down only one hundred thousand. The other nine hundred thousand dollars needed to make the purchase is being financed through debt. This means that with only one million dollars, Firm B owns a total of ten million dollars of houses.

Assuming the same 20% increase in the value of the houses as before, Firm B makes the same two hundred thousand dollars profit per house as Firm A. The difference, though, is that Firm B was able to acquire more houses. Since the firm used more debt, Firm B was able to turn its one million dollars into a whopping three million dollars, a return of two hundred percent. While this example is obviously extreme, it demonstrates a very important point: private equity firms are heavily incentivized to use large amounts of debt to fund their purchases. The more leverage they use, the larger the potential profit, and the more these firms can earn in the form of fees.

Private equity is just one type of a category of asset classes known as alternative investments. Billionaires and many successful investors have been piling into alternative asset classes in recent years to diversify their portfolios and generate attractive risk-adjusted returns. One asset class in particular that had, until recently, been reserved for the ultra-rich is art. And that brings us to the sponsor of our video, Masterworks. Just a few days ago, Masterworks exited its 14th painting, with investors seeing a net return of 17.6 percent. Here's how it works: Masterworks makes multi-million dollar works of art investable without needing millions of dollars. And when a painting sells, you see any potential net returns. Masterworks’ collection is constantly growing because the billionaires haven't bought it all up yet. Now, each of Masterworks’ 14 exits so far have returned a profit to investors, with several sales already this year. Of course, as with any investment, this doesn't automatically guarantee future performance for works not sold, but new offerings on the site can still sell out in hours, which is why you'll want special access and my link in the description.

Now back to the video. For the better part of the last 15 years, interest rates were incredibly low. This made it even cheaper for private equity firms to use debt when doing deals. The majority of private equity buyouts are done with what is referred to as floating rate debt. With floating rate debt, the interest rate the borrower pays floats up or down based on whatever current interest rates are. This hadn't been much of a concern for the past decade because, as this chart demonstrates, interest rates were at rock bottom levels. The prevailing view among many economists was that these low interest rates were going to be a permanent fixture of the U.S. economy and were here to stay. Oh boy, were they wrong.

In response to the highest inflation in 40 years, the U.S. Federal Reserve was forced to raise interest rates aggressively. For most people, the biggest single piece of debt they have is their house. Here in the U.S., the majority of homes are purchased with a fixed rate mortgage. With fixed rate debt, the interest rate stays exactly the same for the life of the loan, regardless of what happens with interest rates. Private equity firms aren't so lucky. The only way the interest rate on floating rate debt can become fixed is if private equity firms purchase what's called a hedge. A hedge essentially locks in the interest rate on a loan for a period of time, protecting the borrower in the event of interest rates were to rise. Think of hedges as almost like an insurance policy against interest rates rising. But like insurance, hedges come at a cost.

Because interest rates were so low for so long, many private equity firms considered hedges a waste of time and money. This short-sighted decision left companies that had been acquired by private equity firms needlessly exposed, with potential devastating ripple effects for the economy and the millions of people these companies employ. Here's what I mean: this is an example income statement for a hypothetical company that has been acquired by private equity. Let's call this company Portfolio Company A, or Port CoA for short. An income statement, also called a profit and loss statement, gives investors insight into the health and profitability of the company.

Going down the income statement, we can see the company was quite profitable before being acquired. The company had one thousand dollars in revenue. Its cost of goods sold, a.k.a. the cost of making the products the business sold, was 400. This leaves the company with a gross profit of 600. Selling, general, and administrative, or SG&A for short, are all the costs associated with running the business that are not directly involved in making the product sold by the company, so think accounting, salespeople, rent, etc. For the company, this was four hundred dollars. Port CoA is left with earnings before interest and tax of two hundred dollars. Our company in this example is a family-run firm and was being run conservatively with no debt. Since there was no debt, there was no interest that needed to be paid. After paying a 22% tax rate, the company was left with an after-tax profit of 156.

With this type of profit margin, this company is a classic target for private equity firms. Eventually, Port CoA was acquired by a private equity firm using debt to fund the purchase price. The private equity firm that bought it used two thousand dollars in debt to do the deal. Since this acquisition happened when interest rates were low, the interest rate on this debt was only three percent. Take a look at the company's financials now. We see here that the company is paying interest on its debt, and that is lowering its profitability.

On an interest-only loan, the two thousand dollars in debt at three percent results in an interest payment of 60. This interest payment ends up lowering the company's after-tax profit to 109. While this profit is lower than what it was before the buyout, Port CoA is still solidly profitable, a win for the private equity firm, as the profit can be used to pay back the debt. However, let's see what happens when interest rates start to rise. Let's take our interest rate up to six percent. This doubles the interest payment the company has to pay from 60 to 120. After-tax profit is now down to just 62. Let's bump up the interest rate even more to ten percent. The interest payment has now ballooned to 200, taking the company's profit all the way down to zero.

This example shows just how dangerous floating rate debt can be for companies. Notice how nothing about the company's revenue or non-interest expenses changed; however, the higher interest payment the company had to make completely zapped all of its profits. Imagine how bad things would have gotten if the economy were to also have slowed, sales would have declined, and the company would start losing significant amounts of money. While this is just an example, this dynamic is starting to happen to companies as we speak. There is an estimated three trillion dollars of floating rate debt outstanding in the private equity industry. Worse yet, over 70 percent of that debt is unhedged.

This doesn't even account for the fact that many of the companies purchased by private equity have decreased in value, as private business valuations have started to come back down to earth. The combination of a slowing economy and higher debt payments is terrible for many of these private equity-backed companies that were already struggling to get by. So now I want to answer the trillion-dollar question that I posed at the beginning of this video: what does this mean for the health of the economy? Well, the answer isn't all too good. According to a study done by the accounting firm EY, private equity employs nearly 12 million Americans. That is approaching 10% of all American workers that are currently employed. That 12 million number doesn't include an additional 7.5 million workers that work in companies that supply private equity-owned companies.

These jobs are also pretty well paid, with the average employee making nearly seventy-three thousand dollars in annual wages and benefits. There is no question that these highly indebted firms will likely have to do significant layoffs in order to try to stay afloat or as part of a restructuring as they come out of a bankruptcy. I mentioned earlier how there are three trillion dollars of these private equity loans in the economy, but how does that compare to other sources of debt? For reference, the total amount of auto loans outstanding is 1.5 trillion dollars, according to the U.S. Federal Reserve. While the housing market is certainly getting a lot of attention, the total outstanding balance of mortgages in the U.S. is 12 trillion dollars. While private equity debt is about one-fourth the size of U.S. mortgages, it is still large enough to have a significant impact on the economy if and or when we start to see a wave of defaults.

There is also another impact from the private equity bubble bursting that could have even longer-lasting impacts. Groups such as pension funds and university endowments rely on private equity to generate returns in order for these organizations to meet their future obligations, whether that be paying retirees in the case of pension funds or university endowments funding colleges' operating budgets. Over the last decade, many of these organizations allocated a larger percentage of their investment portfolio to private equity, as the return from holding cash and owning bonds was virtually zero. If private equity fails to deliver the returns they promised, groups such as pension funds may struggle to have the money to pay retirees.

The economic fallout from the private equity bubble bursting is yet to be determined, but it's definitely something I'm watching closely. So there you have it! Make sure to like this video and subscribe to the channel because a ton of work goes into making these videos, and it keeps me motivated to keep putting out content for you guys. Thanks and talk to you again soon.