For much of the past decade, private equity promised the best of both worlds: the returns of stock markets with the insulation of ownership behind closed doors. Investors from Ivy League endowments to sovereign-wealth funds piled in with the zeal of gold-rush speculators. But now as exits grind to a halt and returns wilt, the promise is beginning to look like a trap.
Private equity has always relied on clever arbitrage. Buy companies cheaply, load them with debt, spruce them up and flog them off at a premium—ideally to the next PE firm. The model depended on three things: cheap capital, rising valuations and eager buyers. All three have gone missing. Exit activity has collapsed. Valuations have softened. And buyers—whether in the form of rival funds or public markets—are nowhere to be found.
The numbers tell the trouble. US equity markets have soared since the pandemic: with the S&P 500 up nearly 95% in the last five years. Yet PE-backed firms are struggling to join the party. Of the roughly 12,000 companies in PE portfolios in America, only 1,500 are being offloaded every year. At that pace it will take nearly a decade to clear the backlog assuming none are added in the meantime.
The bottleneck is already feeding through to fund investors. Capital distributions (the money returned to limited partners) have slumped from around 30% of net asset value to just 10%, according to Bain. Big institutions, including Yale and Harvard, are trying to exit their positions on the secondary market, often at discounts. Complaints about “overallocation” and “illiquidity” are no longer whispered but grumbled openly.
The squeeze has roots in the exuberance of the zero-rate era. Between 2020 and 2022 PE firms gorged on deals. Valuations soared, and managers paid up, often buying from one another. At the peak, so-called “GP-led” transactions—one PE firm selling to another—made up 45% of all exits, according to Harvard Law School. That meant no fresh money left the system. Funds rather passed the same assets around like a parcel in a party that never ended, until the music stopped.
Now the hangover is in full effect. Pre-2020 deals that didn’t make it out in time are stuck, often in companies that look unappetising in a higher-rate world. Deals done in the frenzy of 2021 and 2022 are even worse. They were priced for perfection and financed with cheap debt, which is now painfully expensive. Yields on leveraged loans have climbed to 9.5%, reports PitchBook. Much of that debt is floating rate, and with EBITDA ratios north of eight times for many companies, even slight revenue dips could tip them into default. Moody’s puts default rates among PE-backed firms near 17%, twice the rate for others.
Unable to exit, PE managers are kicking the can. Some are rolling assets into “continuation funds”, vehicles designed to buy time rather than to create value. Others are refinancing with more exotic structures, substituting leverage with complexity. But these manoeuvres are no substitute for actual buyers. And in an environment where growth is scarce and rates remain sticky, playing for time risks eroding what little equity value remains.
PE sold itself as the antidote to public markets: less volatile, more discerning. But in the last five years it has underperformed the S&P 500, according to McKinsey. For an asset class that prides itself on “alpha”—returns above the market—this is an embarrassing revelation. Especially given the opacity, fees and lock-ups investors must endure.
Worse still, the mismatch between allocation and opportunity is becoming unignorable. The market for public equities is roughly ten times larger than that for private companies. Yet some endowments, like Yale’s, have 40% of their portfolio in PE. This is not diversification: it is congestion. Too much capital chasing too few deals in an illiquid corner of the market.
There is no easy way out. The IPO market remains inhospitable, especially for small and micro-cap companies (the natural constituency of PE). Ropes & Gray, a law firm, estimates 50-60% of PE deals fall within this range. Yet public investors are still enamoured with mega-cap tech firms, not middling industrials with high debt loads.
What then is the future of private equity? Some hope a rebound in growth or a pivot by central banks could revive exits. Others place their faith in new markets or sectors: private credit, infrastructure or emerging-market buyouts. But the fundamental problem sticks: too much money chasing too little alpha in a structure that depends on liquidity which no longer exists.
Private equity is not dead. But the days of easy fundraising, serial flipping and double-digit returns may be. The asset class is undergoing a forced diet: leaner, slower and possibly more sober. For now the industry’s famed “dry powder” is less a source of firepower than a signal of indigestion. And the real question is not if private equity can recover. It is whether everyone can get out before the door shuts. ■
