Private Equity's Clock is Ticking, Warns Verdad Advisers

2023

In a recent report by Verdad Advisers, the health of private companies owned by private equity and venture capital firms has raised concerns due to rising debt costs, compressed margins, and negative cash flow. Verdad Advisers' founder, Dan Rasmussen, describes the situation as "pretty scary," noting the deterioration in the margin, debt, and valuation landscape.

The report examines a subset of companies owned by private equity and venture capital firms that are publicly listed or have issued public debt. These companies exhibit characteristics such as sponsor ownership of at least 30 percent, going public since 2018, and being headquartered in North America. Among the 350 companies analyzed, with a combined market cap of $385 billion, around 40 percent were technology companies.

Verdad's analysis reveals that these companies trade at a significant premium to public markets on a GAAP basis. However, they require substantial pro-forma adjustments to achieve comparability. This subset of companies eligible for going public skews towards the higher end of successful outcomes, but their underlying financials paint a different picture.

While the analyzed companies have stronger sales compared to S&P 500 companies, their EBITDA margins have been notably lower, with significant margin compression over the past few years. The research also highlights that 55 percent of the private equity-backed firms had negative free cash flow in the previous year, and 67 percent accumulated additional debt over the past 12 months.

The report indicates that the median leverage for companies with net debt stands at 8.8, corresponding to a Triple-C credit rating, significantly higher than the median leverage for S&P 500 companies at 1.7. Interest costs devour a substantial portion of EBITDA for private equity and venture capital firms, with 43 percent going towards interest payments, compared to 7 percent for S&P 500 companies.

The increase in debt levels, coupled with potentially inevitable multiple compression on exit, poses challenges for these companies. Rasmussen and Verdad Advisers suggest that the companies analyzed are likely among the best offerings from private equity. Despite these concerns, private equity remains a favored asset class for sophisticated investors, with some endowments and family offices approaching a 40 percent allocation.

As private equity's popularity has been fueled by strong trailing returns, low volatility, and a tech-focused approach, the landscape is evolving. Rasmussen points out that valuations have soared due to the influx of capital, particularly through sponsor-to-sponsor deals. However, the current situation suggests that adjustments are necessary.

The Verdad Advisers report underscores the financial challenges faced by private companies in private equity and venture capital, serving as a reminder of the evolving dynamics within this asset class.