A Reckoning For the Private Equity Economy is Here
Too much leverage plus a recession is bad news for employees of private equity portfolio companies
A few weeks ago I read an article on private equity’s use of a strategy known as “dividend recap” to pay themselves special dividends from their portfolio of companies by borrowing in the syndicated loan market. An example of a recent dividend recap deal where the private equity firm Brookfield Asset Management, used was a $4.3 billion syndicated loan to pay themselves on their investment in Clarios International. Brookfield’s move reduced the equity position of Clarios while increasing their debt substantially. My thoughts were that if something like a global recession hit there could be a problem. With significantly more debt, thanks to the dividend recap loan and significantly less equity, given how the private equity investors used the proceeds of the loan to pay themselves, Clarios and its 16,000 employees could have a steep price to pay if something goes wrong.
President Trump’s war on globalization through tariffs has ramped up the odds of a global recession. Two weeks ago on Monday Goldman Sachs forecast a 45% chance of a U.S. recession. Goldman had actually ramped up the chances of recession to 65% Tuesday morning. However, after President Trump announced a 90-day pause on reciprocal tariffs on all countries except China, Goldman brought the recession odds back to 45% two hours later. It is a testament to how volatile economic conditions are when a leading Wall Street economics team changes their recession odds over 30% in couple of hours!
Private equity has been expanding rapidly in the U.S. using leveraged buyouts (LBO) to gobble up companies from the size of Clarios International to your local plumbing contractors. According to a 2022 report from the American Investment Council (AIC), the main lobbying firm for the private equity industry, noted.
The US private equity sector provides employment and earnings for millions of workers. Overall, in 2022, the US private equity sector directly employed 12 million workers earning $1 trillion in wages and benefits
Share of US economic activity. The US private equity sector directly generated $1.7 trillion of gross domestic product (GDP) in the United States in 2022. GDP measures a sector’s or industry’s contribution to the production of final goods and services produced in the United States. The US private equity sector comprised approximately 6.5% of US GDP in 2022.
Suppliers to the US private equity sector. Suppliers to the US private equity sector employed an additional 7.8 million workers throughout the US economy earning $700 billion in wages and benefits and generating $1.1 trillion of US GDP in 2022.
In 2022, the median PE-backed business employed 69 workers. Moreover, approximately 85% of PE-backed businesses were small businesses (i.e., had fewer than 500 employees). PE-backed small businesses directly employed a total of 1.4 million workers throughout the US economy in 2022. These workers earned $135 billion in wages and benefits and generated $240 billion of GDP.
While numbers are not yet available for 2024, we can assume, based on observed growth, that private equity owned companies still directly employ at least, if not more than 12 million Americans. Moreover, as noted by the AIC report, as of 2022 another 7.8 million Americans work for suppliers of private equity owned companies. This means that a sizable amount of Americans are at risk to the private equity strategy failing, and there are strong signs that it is.
Private equity firms rely on two main things to be successful
Strong demand for their debt, leverage loans and high yield bonds
Robust demand for their companies when they need to exit
Regarding demand for their debt, last week saw investors running for the hills as leverage loan and high yield bond funds saw their highest ever weekly outflows. Goldman Sachs actually coined the situation “Flowmegeddon.” Additionally, Goldman more than doubled their default predictions for leveraged loans from 3.5% to 8% and raised their estimate of high yield bond defaults from 3% to 5%.
With regard to demand for their portfolio companies, Bloomberg News noted
What can private equity firms do in
this volatile market? Seemingly nothing. Even with a tariff
reprieve, barriers to buying and selling assets remain. But
buyout barons have their work cut out just operating the
portfolio companies they’re sitting on. As investment
realizations get pushed back yet again, the risk of business
damage at their stuck-on-ice holdings increases.
Investors in private equity such as pension funds are trying to exit by selling their stakes. However, many private equity managers have the ability to make it difficult for investors to exit from existing funds through a sale to another investor. Managers have been putting conditions on investor sales, making investors commit the proceeds of a sale to new deals. This is big difference from just a year ago when investors demand and deal making made a strong comeback from 2022-2023 when the Federal Reserve was quickly raising rates.
While private equity managers and investors might lose substantially, employees who work for their companies could be in for a lot worse. If private equity managers can’t sell their companies and they cant’t refinance or amend their debt in a weakening economy they will go into survival mode which generally means cutting expenses, especially labor expense, to the bone.
Recessions are never good for American workers. Recessions for Americans working for private equity companies might be a whole lot worse.