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The longer a bear market drags on, the better the chance that pain will spread beyond stocks. So with the US bear market entering its seventh month, it’s not too soon to think about what other risks might be lurking. Private equity is at the top of the list.

The private equity industry, which as its name implies invests in shares of private companies, has ballooned into a sprawling, high-powered, moneymaking machine over the past four decades. In the 1980s, it could legitimately claim to be a small club of rich investors, but no more. Data around private equity is scarce because its dealings are, well, private, but available numbers give a clear enough picture of its enormous scale.

According to Preqin, a leading provider of global private equity research, there were 28 private equity firms in 1980 across the industry’s three chief strategies: leveraged buyouts (buying mature companies using mostly borrowed money); growth equity (investing in maturing but still relatively new businesses); and venture capital (betting on startups). Now there are more than 9,200 firms managing close to $7 trillion.

Suffice it to say, the secret is out. Most institutional investors, including pensions and college endowments, allocate a significant portion of their portfolios to private equity, often a third or more. It’s also a core investment at big money-management firms, notably Wall Street banks. Even Vanguard Group, known mostly for its low-cost index funds, now offers private equity to eligible clients. The only investors who don’t own private equity these days are retail investors, who are prohibited from doing so by US securities laws.    

The reason private equity is so popular is that it has made a fortune. Cambridge Associates’ widely followed US Private Equity Index, which includes buyout and growth equity funds, posted a return of 14.3% a year over the past 25 years through 2021. That’s 4.4 percentage points a year better than the US stock market and 6.3 percentage points better than the global stock market, according to Cambridge Associates’ calculations. Its US Venture Capital Index performed even better, advancing 28.7% a year over the same time.

But those heady days are almost certainly over. Private equity was blessed with ideal conditions in recent decades, an environment it may never encounter again. Interest rates fell from record highs in the early 1980s to record lows two years ago, allowing buyout firms to borrow and refinance ever more cheaply along the way. At the same time, equity valuations rose to historic highs from historic lows, lifting the value of most companies. That combination of cheaper leverage and rising valuations is unbeatable.

Private equity had other advantages in its earlier days. Most investors had no exposure to private equity in the 1980s, so there was a lot of room for growth. There was also little competition, so managers had their pick of deals. When money began pouring into the space, more companies were suddenly able to raise capital without going public, which further expanded the field of potential investments. And while valuations were still low, existing private equity firms could sell their investments to newer firms for a hefty profit but still cheaply enough that the newcomers could also make money on a future sale.  

Those advantages are no longer in play. Interest rates are rising from record lows; valuations are stretched; private equity is crowded, forcing firms to pay more for lower-quality businesses; and investors who can own private equity already have a sizeable stake. The best private equity can hope for is that interest rates remain low and valuations hang around current levels, allowing the industry to churn out satisfactory – if no longer spectacular — returns investors can live with.  

It could get worse, though, and cracks are already beginning to show. Startup valuations are declining, possibly rivaling the selloff in technology stocks, and funding for new ventures is becoming more scarce. Banks are bracing for losses on buyout debt amid rising rates and a broader decline in corporate debt, leaving them more wary about extending new loans. Just as cheaper leverage and rising valuations were once a boon, rising interest rates and lower valuations will bite.

Those warning signs haven’t yet dampened investors’ enthusiasm for private equity, but they also haven’t had to confront them. Unlike publicly traded companies, the value of private businesses doesn’t fluctuate with the whims of the stock market. Absent a transaction to establish price, private companies are worth pretty much what their owners say they are, and private equity is no hurry to concede that its bets may be souring. But if this bear market persists, private equity firms will have to concede that their investments have declined in value, and the writedowns could be substantial.

And it may not end there. The real danger for private equity is a longer-term reversal of the past four decades, where interest rates continue to creep higher while valuations grind lower. It would force private equity firms to continue marking down the value of their investments, causing performance to sag. Just as investors chased private equity when it was hot, they can run the other way when it cools. They’ll start by reducing their allocation to private equity, turning off the torrent of money the industry has long taken for granted.

If the slump lasts long enough, investors will pressure private equity firms for an exit, but it won’t be easy to find buyers for their companies. Amundi SA’s chief investment officer, Vincent Mortier, compared private equity to a pyramid scheme recently. A better comparison might be the game of hot potato. Private equity firms have kept the party going mostly by selling companies to one another, which has allowed them to return money to investors. Also, business owners who sell to private equity often reinvest some of their newly minted fortunes back into private equity. All of that requires a steady stream of fresh capital to keep going.

Without continued investment, private equity firms may have to offer discounts to attract buyers, and investors may eventually want out bad enough that they’re willing to absorb losses. They would do better to hang on, but don’t assume private equity’s “sophisticated” investors are immune to poor financial decisions. Rich investors can chase performance as well as anyone, as the private equity boom has demonstrated. They can also retreat in a panic like any other investor, and perhaps more so because they have more to lose.

A disorderly unwind would be devastating for the industry and investors, but the ripples would extend well beyond. More than a few bankers, lawyers, accountants, consultants and engineers have been richly compensated to grease the wheels of private equity and will face a painful pay cut. And they’re the lucky ones. Private equity now owns large swaths of the US economy, including housing, health care, media and countless other industries and local businesses. A winter for private equity would be hugely disruptive to those businesses and for the workers, families and customers who rely on them.  

Just how disruptive and how many are in harm’s way is hard to know because unlike public companies, private equity operates in the shadows. That may have been tolerable when private equity had a smaller footprint, but now it’s hard to justify. One reason public companies are required to disclose details about their business is that there’s a lot riding on their success or failure. The same is now true of many businesses that private equity owns.

While the industry is riding high, it will use its vast treasure and influence to ward off any attempts to regulate it. There have long been calls to close the so-called carried interest loophole, which inexplicably taxes private equity mavens at a lower rate than many ordinary Americans by treating much of their income as capital gains rather than ordinary income. Yet the loophole persists. A reckoning for private equity would give policy makers an opening to make changes. One of them should be to require private companies above a certain market value or with a large number of investors to comply with the same disclosure rules that apply to public companies.  

Whatever happens, private equity isn’t going away, nor should it. It plays an important role in the broader financial system by providing capital to new ventures and bailing out struggling but salvageable businesses. But it has grown well beyond that now. Every downturn seems to require some soul searching about risks that escaped notice. Sooner or later, one of those will be private equity.   

More From Other Writers at Bloomberg Opinion:

• Why Did a Fund Chief Call Private Equity a ‘Ponzi’?: Shuli Ren

• Wall Street Has a Big Buyout Loan Headache: Paul J. Davies

• Matt Levine’s Money Stuff: The SPAC Bust Is Expensive

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

Nir Kaissar is a Bloomberg Opinion columnist covering markets. He is the founder of Unison Advisors, an asset management firm.

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