There’s No Easy Exit for Companies Backed by PE and VC
Verdad Advisers’ Dan Rasmussen argues that rising debt costs, compressed margins, and negative cash flow make for a “pretty scary” picture of the health of private companies.
The true value of private equity- and venture capital-owned companies — a source of much debate — can be hard for outsiders to know. But Verdad Advisers’ founder Dan Rasmussen and senior analyst Chris Satterthwaite have figured a way to peek behind the curtain — and what they’ve found is not pretty.
“The clock is ticking” for private equity, Rasmussen told Institutional Investor. “The margin picture was bad and has gotten worse, the debt picture was bad and has gotten a lot worse, and the valuation picture was bad and has gotten a lot worse.” Combined, it’s “pretty scary,” he said.
“These are really expensive overleveraged companies with deteriorating financials,” he concluded.
The companies analyzed in Verdad’s new report are “unprofitable on an EBITDA basis, mostly cash flow negative, and extraordinarily leveraged mostly with floating-rate debt that is now costing nearly 12 percent,” it found.
For their analysis Rasmussen and Satterthwaite looked at a subset of companies owned by private equity and venture capital firms that were either publicly listed or have issued public debt; had sponsor-ownership of at least 30 percent, had gone public since 2018, and were headquartered in North America. On top of that the largest shareholder had to be a manager with a recognizable name. Some 350 companies with a market cap of a total $385 billion met the first criteria. The private companies with public debt were worth another $360 billion. Verdad said the analysis provides a “partial reflection of what’s currently going on in the opaque but important asset class.”
All told, the companies they analyzed are equal to 6.5 percent of the $11.7 trillion in private equity assets under management. About 40 percent were technology companies.
The analyzed companies were also exceedingly expensive. “These companies trade at a dramatic premium to public markets on a GAAP basis, only reaching comparability after massive amounts of pro-forma adjustments,” Rasmussen and Satterthwaite found. “Given that this is the subset that was eligible to be taken public, we would expect this sample to skew toward the higher end of successful outcomes.”
“There is a disconnect between what investors think private equity is and what private equity actually is,” Rasmussen told II. “When you hear about private equity, you think these are great businesses that are well capitalized by thoughtful sponsors that are going to improve the businesses. When you look at the underlying financials of the companies, you come to a different view.”
While the companies had stronger sales than S&P 500 companies, that wasn’t the case when it came to EBITDA — earnings before interest, taxes, depreciation, and amortization. Verdad’s analysis looked at both pro-forma EBITDA, which half of the companies reported, and GAAP EBITDA. Not only were the margins lower than the S&P 500 in both cases, Verdad found that there has been “significant margin compression over the past few years.”
The S&P500 companies had margins of about 20 percent in 2022, while the margins at PE and venture capital companies on a GAAP basis were under 5 percent, and 10 percent on a pro-forma basis.
The research found that 55 percent of the PE-backed firms were free cash flow negative last year, with 67 percent adding debt over the past 12 months.
The Verdad report found that the median leverage for the companies with net debt have a leverage ratio of 8.8, which would give them a Triple-C credit rating, in contrast to the median leverage for the S&P 500 companies of 1.7. Interest costs ate up 43 percent of EBITDA for the median PE-VC company, compared with 7 percent for S&P 500 companies.
Moreover, the report suggests that much of the increase in debt is not yet reflected in reported numbers, as rates rose over 5 percent in 2022.
“With the S&P 500 trading at 13.6 times GAAP EBITDA, multiple compression on exit seems all but inevitable for many deals,” they wrote.
Moreover, Rasmussen and Satterthwaite note that “these companies are probably some of the best private equity had to offer.”
A strong equity market and the boom in Special Purpose Acquisition Companies created a window for PE-backed companies to go public, but that is now over. “Private investors took public what they thought they could,” they said. “Presumably, what remains in the portfolios was what could not be taken public.”
“From a quantitative perspective, the fundamentals of sponsor-backed companies look frightening,” the report concluded. “Yet private equity remains the darling asset class of sophisticated investors, with many endowments and family offices nearing a 40 percent allocation.”
Rasmussen said in the interview that private equity has been popular because the trailing returns are very good, volatility appears low, and the asset class has been tech focused, which until recently “had a great run.” The flood of money into the asset class also pushed valuations “higher and higher,” especially with the assistance of sponsor-to-sponsor deals, he said. “But something’s got to give.”