Blame, Definition, and the Promise of Private Equity#

You hear a lot of talk about private equity these days. It’s gotten blamed for, well, pretty much every problem in America, from folks losing their jobs in mass layoffs to the price of homes being just impossible.

Now, look, some of that frustration? Totally fair. But some of it might just be coming from some wealthy folks who didn’t quite land that fancy summer job at a big firm like Blackstone.

Whatever your personal reason is for not being a big fan of private equity, you’ll probably be interested to know that after shooting up like a rocket, the whole way this industry works is now staring down what looks like a wild collapse.

There’s a quote that sums it up nicely: “when you have a group sitting as a state pension fund or all they’re doing is lying a little bit to make the money come in.” Yeah, that kind of nails it.

This is because when private equity firms borrow money to buy a company, that borrowed money? It becomes the responsibility of the company they bought, not the private equity firm itself.

Often called one of the most troublesome forces in American, and even global, economic life, private equity is pretty straightforward when you boil it down:

• It’s simply any investment you make into assets that aren’t listed on public markets.

Think about it: There are hundreds of thousands of really profitable and promising businesses right here in America, and millions more around the world. But you could never buy a piece of them just using an app like Robinhood with some spare cash.

Why? Because these are private companies. They aren’t listed on the big public stock exchanges. And because they aren’t public, they don’t have to tell everyone everything about their finances the way public companies do. This makes it super hard and takes a ton of time for a regular investor to figure out if a business is worth buying, and even harder to figure out what it would be worth if you did buy it.

This is where private equity firms jumped in. They acted as the middlemen. They offered rich investors and managers of big pools of money, like pension funds, a way into this market that most people couldn’t touch.

Their pitch to you, if you were a billionaire or ran a pension fund, was pretty simple:

• They could get you a higher average investment return than you’d ever see in the plain old stock market.
• Your returns would bounce around less (be less volatile).
• Your money would be safer from big market crashes.

How could they promise this? Their story was that they had a fantastic team – a “crack team” even – of the absolute best analysts in the world. These experts would do all the tough work of finding and buying these private companies, or other unique investments known as alternative assets, on your behalf. And then, their job was to squeeze out every single dollar they possibly could from these investments.

Sounds almost too good to be true, right? Well, guess what? It is.

The Downfall: Why Private Equity is Facing a Wild Collapse#

Private equity has pushed its way of doing business way, way too far. Now, it’s sitting on assets worth trillions of dollars that frankly, nobody really wants to buy.

On the surface, that might sound like a good thing if you’re a regular person who’s been affected by the layoffs and cost-cutting that private equity has become famous for. Right?

Wrong.

There are four main reasons why private equity is starting to crumble. And here’s the kicker: there are also four main reasons why it looks like all of us, regular folks included, are going to be the ones who end up paying the price for it.

Reason 1: The Returns Weren’t What They Seemed#

The first big reason is that those amazing returns they promised weren’t as solid as they looked on paper.

Have you heard of the Schrödinger’s cat thought experiment? It’s a physics thing. Imagine you put a cat in a sealed box with a little vial of poison that has a 50/50 chance of breaking open or doing nothing. Until you open the box, the cat is, in a weird physics way, both alive and dead at the same time. Physicists use this to think about tiny particles (quantum mechanics), but private equity managers? They’ve used a similar idea to get their hands on trillions of dollars with one really simple trick.

My friend, Ben Felix, who’s a professional money manager and makes really clear, no-nonsense finance content, was one of the first people to point these specific problems out to me in something he posted online (on Twitter or X now). You should seriously follow him if you aren’t already.

Here’s the trick: The value of those private companies and the alternative assets that private equity firms built their whole business on? It’s really hard to figure out exactly what they’re worth. Even the people working inside those companies, who have access to all the financial details, struggle with it.

See, an unlisted private company doesn’t have its stock price blinking and changing every second like a public company’s does. This makes their shares:

• Harder to buy.
• Harder to sell.
• Harder to assign a clear value to.

In the past, if you invested in something that was hard to sell quickly (this is called being illiquid), investors expected to get paid extra for taking on that difficulty. It was a premium you got for the trouble.

Think about it: If you’re a wealthy investor and suddenly need a lot of cash for an unexpected bill, it’s way easier to sell shares in a public company or listed bonds. You can do it fast at a price everyone knows. Liquidating a big chunk of shares in a private company, or selling things like art, real estate, or patents (those alternative assets)? That takes time. You’re looking at least a week just to find someone to buy it, draw up papers, and agree on a price. And that’s being optimistic; it’s often longer.

Plus, selling these kinds of assets usually needs someone like a realtor, an auction house, or a team of Investment Bankers to handle the deal. And guess what? They all take a cut of the money you get, which can really eat into your profits.

This is why assets you can sell quickly and easily at a well-known market price (more liquid assets) are just generally better. The only real reason you’d tie up your money in something less liquid is the hope that it would give you higher returns for less risk.

But private equity firms twisted this. They took the biggest weakness of their assets – how hard they are to value and sell – and turned it into a marketing tool.

If they never actually sell the assets they own, and they don’t have to show everyone their detailed financial reports, nobody really knows what their collection of investments is truly worth. So, they could just pick a higher number each year and say, “Look! Your money grew!” As long as they didn’t claim something totally ridiculous, it was hard for anyone to call them out.

A large private equity firm named EnCap actually got into big trouble for doing this exact thing. Their controversy was specifically about their investment in an oil and gas company called Southland Royalty.

Here are some details about that investment:

• They created Southland with a total investment of over $1.1 billion.
• EnCap put in 80% of that capital, which was $880 million.
• Other investors made up the remaining amount.
• With this new company, they bought oil and gas fields around the U.S., including places like the San Juan Basin in New Mexico and the Green River Basin in Wyoming.
• They also bought 313,000 acres from another oil company.

When EnCap set up Southland in 2015, they were hoping oil prices would go back up after a big drop the year before. In June 2014, oil was nearly $100 a barrel**. But by the same time in **2015**, it had fallen to **$55 a barrel.

The problem? Oil prices never really climbed back up the way they hoped, and the new fields they bought didn’t pump out nearly as much oil as they expected.

Fast forward to September 2019. Even though things weren’t going well, they were still valuing Southland at pretty much the same amount as their original big investment. But then, just two months later, in November 2019, they suddenly said it was worth $0 and filed for bankruptcy.

When private equity firms are honest and show the real value of their companies on their books, it’s called marking to market. But since they are constantly competing with other private equity firms to get rich investors and funds to give them money for their next big fund, they aren’t always going to be truthful about the investments that aren’t doing well – especially if they don’t have to be public about it.

Private equity managers could even make this illusion stronger by only selling the investments that were doing the best. This made it look like everything in their portfolio was doing equally well, even if most of it wasn’t.

The very fact that these investments didn’t have prices updated all the time actually made them more appealing to certain fund managers. It let them tell their own investors that their money was growing smoothly and steadily, even when the public markets were bouncing all over the place.

For a while, this kind of worked. After all, something is technically worth whatever someone is willing to pay for it at that moment. But now, the investing public has started to catch on. They’ve realized that private equity firms are holding onto a lot of stuff – let’s just call it “garbage” – that is going to be incredibly hard to sell, especially for the prices they’ve claimed it’s worth.

Look, every investment has risks. And if this was just a story about finance guys promising the moon to rich people and not delivering, it wouldn’t be a big deal and probably wouldn’t need a whole explanation video.

But here’s the crucial part: A lot of the money invested in private equity? It’s actually your money, often through things like your retirement or a pension fund. And if this convenient story they’ve been telling falls apart, it’s very likely not the private equity partners who will be losing their jobs.

So, it’s time to understand how money works to see how private equity didn’t live up to its big promises, and how we might all end up paying the price for that not-so-little lie.

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The Rise That Led to the Fall#

Alright, back to private equity. It used to be something really exclusive, only available to the super rich and those considered “sophisticated” investors. And back in those days, it often did deliver returns that were better than the regular market.

Even someone like Warren Buffett’s Berkshire Hathaway owes a lot of its early success to acting kind of like a private equity firm, making famous buys like the Nebraska Furniture Mart and Heinz.

Investors saw how well it could work, and now? It’s gone totally mainstream. According to numbers from Morgan Stanley (published by the Financial Times), the amount of money managed by private equity firms (assets under management) has skyrocketed by 1,400% since the year 2000.

Some specific types of private equity strategies, like growth equity, have grown even faster. There’s now 10,000% more capital in that space than there was just 24 years ago.

Reason 3: The Desperate Push for Returns (and the Cost)#

Private equity managers make most of their really big money from getting investment returns that are significantly better than the general stock market (like the S&P 500).

But data from places like Cambridge Associates, Capital IQ, and Bloomberg shows that all this competition to buy companies has driven the prices up. Using a measure like EB over EV (which helps figure out returns), the average private equity Fund actually performs worse than the S&P 500 before they even take out their fees. Again, my friend Ben Felix, whose actual job is picking good investments for his clients, shared this information.

To try and stay relevant and keep their investors happy (and the bonuses flowing), private equity managers have started doing two main things:

1. They are taking on as much debt as they possibly can (leveraging up their businesses).
2. They are cutting costs wherever they can to boost the company’s earnings and make the numbers look better.

The most common way they cut costs? Laying people off. A report by the Private Equity Stakeholder Project found that, on average, companies acquired by a private equity firm saw job losses of 4.4% in the years right after the purchase.

That might not sound like a huge number, but you have to remember two things:

• Most companies actually add employees over time as they grow.
• This study was done during a period when the overall unemployment rate across the entire country actually fell by 4.5%.

So, while the rest of the economy was adding jobs, companies bought by private equity were cutting them.

But cost-cutting hasn’t just meant layoffs. It’s also led to businesses offering noticeably worse service to their customers. This is annoying if they buy your favorite fast-food place and start using cheaper ingredients in your Whopper.

But private equity companies have also slashed costs in places that provide essential services to vulnerable people, like:

• Nursing homes
• Preschools
• Hospitals
• Prisons

According to studies from the National Bureau of Economic Research, as well as reports in places like The Atlantic, The New York Times, and Bloomberg, this relentless push to lower expenses and keep profits high has been responsible for tens of thousands of premature deaths among some of the country’s most defenseless people.

Private equity managers might be willing to do things like this to keep their profit margins high and protect their share of the investment profits (carried interest), but now the whole industry has gotten so massive and its actions so noticeable that it’s really starting to get the attention of the people who make and enforce the rules (regulators). And these regulators are starting to push back hard.

The Heat is On: Regulators and Politicians Step In#

The growing size and controversial actions of the private equity industry are attracting serious scrutiny.

Just at the end of last year:

• The Senate Budget Committee announced they were launching a bipartisan investigation (meaning politicians from both major parties are working on it) specifically looking into private equity ownership of hospitals.
• Almost at the same time, the White House announced they were cracking down on business practices in the space that prevent fair competition (anti-competitive practices).

Congress is also trying to pass a new law that would limit the tax breaks currently available to large corporate investors who are buying up single-family homes. Right now, these investors can claim the interest they pay on loans and the value decrease over time (depreciation) as write-offs on their taxes. This makes buying family homes a really appealing investment for these big funds, especially since they’ve gotten too large to easily buy smaller private businesses anymore.

Twenty years ago, private equity was a pretty niche thing that most people had never heard of. But its incredibly fast growth and the promise of huge returns grabbed the attention of big investors. These big investors then, arguably, took a good thing too far, crowding the market and changing how it works.

Now, it’s not just big investors paying attention. It’s also got the attention of:

• Young people who can’t afford to buy a home.
• Elderly people who are struggling to afford care.
• Politicians who feel they have to be seen doing something to fix these problems.

If you’re interested in learning more, I’m actually writing an article over on my completely free email newsletter, Compound and Daily, about the best and worst firms and investors in the private equity world. If you want to read that, and get all my videos a day early, you should sign up at the link provided below.

Reason 4: Never Meant to Last Forever#

Here’s the bonus, fourth reason why private equity seems headed for a collapse: it was never really built to stick around for the long haul in the first place.

If you want to understand how the very early investors in this game made billions and then got out, you should check out my previous video on “what the private Equity actually does”. It shows how the model was set up right from the start.

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