As China announced 34% retaliatory tariffs overnight, triggering a further swoon in European stocks and US equity futures, experts are grappling with which sectors and companies will be hit particularly hard. Admittedly this is speculative since pretty much no one (except specific manufacturers themselves) has granular data on the amount and country mix of foreign elements in their cost of goods sold. And it’s remotely possible that some nations will get relief via sufficiently large acts of prostration.
However, Mr. Market worked out that Apple and Nvidia looked seriously exposed, and punished them suitably. Oddly, the press took less note of the bloodbath among big private equity stocks. This swan dive strong suggest that private equity fund limited partners like public pension funds (as in investors in the funds, as opposed to buyers of the public stocks) are in an even more perilous position. Remember, roughly 2/3 of the income at private equity funds comes from fees that have nothing to do with how well the investment does, like transaction fees, management fees, “fees for doing nothing” aka monitoring fees. By contrast, for fund investors, a simple way of thinking about private equity is to view it as levered equity.1 Leverage amplifies gains and losses. So a levered portfolio will do worse in a bear market than one with no borrowings.
And remember, private credit, which are debt funds, often managed by big private equity firms, have private equity debt (“leveraged loans”) as a substantial portion of their assets. Private equity firms already have a wee problem with bankruptcies among their portfolio companies. Unless there is a big U turn on the Trump tariffs, defaults and bankruptcies look set to rise, which have the potential to deliver losses to credit fund investors….who again have public pension funds, life insurers, private pension funds, foundations and endowments, and sovereign wealth funds as their big holders.
In addition, the blowback of more distress among private-equity-owned companies will be serious. Most are unaware of how significant private equity fund holdings are relative to the real economy. For instance, in its initial S-1 filing in 2007, KKR said the total staffing among all of its portfolio companies put it at the 5th biggest employer in the US. If anything, its share is likely to be larger now.
First to Bloomberg yesterday on the hit to private equity stocks:
Shares of the biggest US private equity firms plunged on Thursday, some by the most since the early days of the pandemic, as US President Donald Trump’s sweeping tariffs shocked global markets.
Apollo Global Management Inc., Blackstone Inc., Ares Management Corp., Carlyle Group Inc. and KKR & Co. all tumbled at least 10% during the session after Trump announced the steepest tariffs in more than a century, threatening to wreak havoc on supply chains and crush economic growth.
As of 1 p.m. in New York, KKR and Apollo were the second- and third-worst performers in the 73-company S&P 500 Financials Index.
The big reason for the share slump was that tariffs will make a difficult fundraising environment worse. As the Financial Times reported last month, in Private equity industry shrinks for the first time in decades:
Private equity assets under management fell last year for the first time in decades as investors confronting a $3tn backlog of ageing and unsold deals pulled back from committing new funds to the sector.
Buyout firms managed $4.7tn in assets as of June last year — down about 2 per cent from 2023, according to a report from consultancy Bain & Co.
The decline in assets was the first since Bain began tracking industry assets in 2005.
Even during the 2008 financial crisis, the private equity industry recorded modest asset growth, underscoring the magnitude of the challenges currently facing buyout groups.
Fundraising has slowed sharply as private equity groups have struggled to sell assets and return cash to investors, causing large pension funds and endowments to retrench, said Hugh MacArthur, chair of Bain’s global private equity practice….
The proportion of a fund’s net asset value that buyout managers return to their investors as cash has fallen to about half the historical average in recent years.
The lack of distributions has squeezed pension funds, which need regular cash payouts to fund their commitments to retired workers.
In 2024, the distributions from the private equity industry as a percentage of net assets fell to their lowest in more than a decade at just 11 per cent, Bain found.
Mind you, it’s not that these companies can’t be sold, but that they can’t be sold at prices that are peppy enough to provide decent-looking returns. But the distortions of IRR mean that selling a company relatively early in a fund’s life provides more of a goose to apparent returns than the true apples-to-apples of “public market equivalent“.
Keep in mind also, unbeknownst to most outside the industry, private equity has increased the leverage of its strategy over time. Two of the big devices:
Leverage on leverage, via borrowing at the fund level as well as the investee company level. These loans are called “subscription lines”. And guess what the source of the funding is? The yet-to-be-spent commitments of the limited partners! As in say, Apollo can hit up CalPERS if a fund in which CalPERS has invested and which Apollo has drawn down on its subscription line has a liquidity problem severe enough that Apollo can’t meet the subscription line obligations.
Increased operating leverage. One might also call it asset stripping. For entities that owned their real estate, such as retailers, hospitals, and restaurants, private equity firms will sell the real estate to investors and lease the property back to the former owner. The price of the rental payments is set high so as to assure a hefty sales price for the real estate. Needless to say, the burden of the new high rent payments makes the business even more likely to fail. And particularly for retailers and restaurants, the reason they had owned their premises in the first place was that their industry was cyclical and they wanted to keep fixed obligations low so as to be able to ride out bad time.
So imagine what happens when these companies face both a cost squeeze and a big fall in demand due to the Trump tariffs. They will be failure-prone. And unlike in the private equity bloodbath of the late 1980s-early 1990s, private equity collectively is important enough to the economy that the scale of private equity business failures could intensify a downturn.
Now let’s consider what this mean for investors, particularly public pension funds. Private equity will under duress as stock prices as swooning. Private equity accounts for 14% of fund allocations, but some public pension funds like CalPERS are short of their targets. While private equity funds engage in a lot of fakery in their valuations (they are the only asset class not required to get independent valuations), pension funds, irrespective of what the valuations say, will feel even more squeezed due to private equity not returning anywhere near as much cash as expected via sales of portfolio companies.
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1 This take is actually flattering to private equity, which as we have been documenting for many years, has not outperformed public stocks since 2006. Long-standing rules of thumb held that private equity should outperform public stocks by 300 basis points (3%) to compensate for the greater risks of leverage plus illiquidity.
