Private Equity Poised to Face a Reckoning After Gilded Decade
(Bloomberg) -- A turning point has arrived for the private equity industry, whose velvet-rope deals and outsized returns defined the past decade’s era of ultra-wealth on Wall Street.
The jolt of the coronavirus pandemic, which halted most economic life in the U.S., has sent shockwaves through the industry, which in recent years infiltrated virtually every corner of the business world from real estate to hospitals, newspapers and restaurants.
Amid the chaos, the reverberations are just beginning. On Friday, Apollo Global Management Inc., one of the sector’s giants, said that as of March 31 it was facing the prospect of returning nearly $1 billion of profits to its investors. While executives later said April’s market gains have made that less likely, the announcement pointed to the potential pain to come.
Private equity thrived in the years following the last financial crisis, taking advantage of low interest rates, relatively lax regulation -- especially compared to Wall Street banks -- and eager investors looking for returns. Now, some of the companies it levered up are among those most in financial danger. While the industry is on sure footing, with about $1.5 trillion in cash on hand, there’s a likelihood that the extreme money-making days are over for firms and their clients, at least for now.
“It’s cyclical, like every other investment product -- sometimes you’re the windshield and sometimes you’re the bug,” said Scott Conners, president of FlowStone Partners, which acquires portfolios of private equity fund interests. “Now is not a great time to own assets that you put in the ground over the past three years, but money that you put in the ground tomorrow will probably do well.”
Apollo said that the firm, together with some current and former employees and partners, could be on the hook to give back $965.4 million in profit taken as of the end of March. The funds facing potential payouts, known as clawbacks, would have to make $4.6 billion from investment gains and income to avoid owing anything, the company said.
On a call with analysts Friday morning, co-founder Josh Harris said that the firm estimated an 11% market gain would mean no clawbacks were required (the S&P 500 Index rose 13% in April), but didn’t provide further details.
Clawback provisions can mean private equity executives have to return cash distributions to prevent their share of profits from exceeding a set amount, typically 20%, when a fund’s remaining holdings suffer a permanent decline in value. They’re more likely to occur when managers take profits early on in a fund’s life; if that fund gets hit later on, the earlier profits would be owed back.
While so far unrealized, clawbacks may become reality for some in an industry that bet big on sectors such as travel, energy and retail that have been devastated by the coronavirus outbreak and lockdown measures taken to halt its spread.
Apollo is the first major alternative asset manager to suggest it may have to pay back profits. But it’s not just clawbacks. Big drops in asset values at firms including Carlyle Group Inc. and Blackstone Group Inc. could mean lower compensation.
Blackstone wrote down its firmwide potential future carry payments to employees -- which it describes as unrealized performance allocations compensation -- by $1.4 billion in the latest quarter, compared to accruals of about $95 million in the prior two quarters.
Carlyle executives said this week that four funds fell out of carry in the first quarter, including a credit opportunities and a European buyout fund.
“If you go back to the great financial crisis, we had the same thing happen,” Carlyle Chief Financial Officer Curt Buser told analysts on an earnings call Thursday. “Our fourth U.S. buyout fund fell out of accrued carry. Well, guess what? I am really happy that I was invested in that fourth U.S. buyout fund, because it did great.”
Firms such as Blackstone, Apollo and KKR & Co. have been among the greatest wealth creation machines in history, minting dozens of billionaires at the top, legions of very wealthy partners and even offering salaries of more than $200,000 to those straight out of college.
Leading figures from the industry are a recurring presence on the Bloomberg Billionaires Index, a ranking of the world’s 500 richest people. They include Blackstone’s Stephen Schwarzman, who has an $18 billion fortune, and KKR’s Henry Kravis, who is credited with a $6 billion net worth. Apollo’s Leon Black is calculated to be worth $8.5 billion.
Demand for private equity has ballooned from pension funds, sovereign wealth funds and ultra-rich families, while soaring markets made it easier to buy and sell companies or invest in credit.
Some of the biggest firms went public, while more recently others cashed in by selling stakes to investors such as Neuberger Berman’s Dyal Capital Partners. That helped unlock some of their wealth, the bulk of which is often tied up in investment funds, and created a fresh cohort of new billionaires even as they kept control of their firms.
Despite the current challenges, senior executives are reassuring investors about their firms’ ability to weather the current crisis. Working in their favor is that the outcome of the previous recession was soaring assets and returns for the industry.
Blackstone is “designed to ride through a difficult environment,” President Jon Gray said last week. Amundi SA is “solidly armed” to eventually emerge stronger, Chief Executive Yves Perrier said Thursday, the same day that Carlyle’s co-CEOs said they were taking a “patient approach.”
“Private equity is already taking advantage of deeply discounted values by buying when other capital structures won’t,” Antoine Drean, chairman and founder of private equity fund advisory Triago, said by email.
Drean said he expects the industry to emerge from the crisis with an enhanced reputation for creating value and minimizing risk. “It’s an opportunity for private equity investment stars to emerge,” he said.
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