Editor's note: Some investments will do better than others in today's volatile market... But when it comes to private-equity firms, Joel Litman – founder of our corporate affiliate Altimetry – says many of these businesses are outright dangerous. In this piece, adapted from a recent issue of the free Altimetry Daily Authority e-letter, Joel explains why this model just isn't working... and why ignoring the warning signs could lead you to disaster.

Private Equity's 'Game Plan' No Longer Works

By Joel Litman, chief investment strategist, Altimetry

Private-equity ("PE") firms never meant to run "forever funds"...

Depending on how big these companies are, PE firms may run several investment funds at once... and launch several new ones each year.

Here's how it works... A PE firm raises cash from investors to put into new funds. These funds have a typical life cycle between seven and 15 years.

In that time frame, the fund does its best to buy cheap companies with debt... fix up their operations... and then sell those businesses either to other PE firms or via the stock market.

Once all the companies are sold, the PE firm will then "retire" that fund, return cash to its investors, and start working on a new fund.

Today, though, that game plan isn't working like it's supposed to...

As I'll explain, PE firms are struggling to offload their funds' investments. And that's a big problem for both private and public investors...

Usually, PE firms have two major options for selling their portfolio companies...

The first is to sell to another PE firm.

Again, PE firms often spend a few years fixing up a business's operations to make the company more efficient. Those businesses then become more attractive investments for larger firms that wouldn't have looked in their direction originally.

However, this option has become much less appealing since interest rates started rising. That's because PE firms usually buy companies with debt to increase their returns. And with rates above 5%, it's much harder for these deals to make money.

The second option is to sell the company in an initial public offering ("IPO").

IPOs are an important mechanism for PE firms. (Without them, these firms would be stuck selling the same businesses to each other forever.) After a PE firm fixes up its portfolio companies, it can get a new group of investors in on the action via an IPO. Even better, these deals don't require boatloads of new debt.

In 2021, PE-backed IPO volume reached an all-time high of nearly $140 billion. Since then, volumes have plummeted... They're now at their lowest levels since the Great Recession.

That's because recent PE-backed IPOs have mostly flopped...

While the process of going public doesn't add debt to these companies, PE-backed companies still tend to carry a lot of debt. And that makes public investors nervous with today's high interest rates.

Just look at PE firm Permira, for example. It took shoe company Dr. Martens (DOCS.L) public in January 2021. Its stock is down roughly 80% since then.

Then there's payment-software company EngageSmart (ESMT), which was taken public by General Atlantic in September 2021. Today, its stock is down more than 30%.

That's a bad look for the PE business model. And it's making it harder for PE firms to take their holdings public today... This year, PE-backed IPO volumes are on track to be less than $20 billion.

It has gotten so bad that PE firms have started buying back their failed IPOs. They're hoping that taking the companies private again will allow them to find a better way to make some money.

Unfortunately, the damage is already done. It's clear that PE firms are failing at their game plan. And that's going to make it harder for them to sell in the future.

In fact, more PE firms are entering "zombie" status, where they can't close old funds and start new ones.

All in all, beware the PE firm that tries to get rid of its companies...

While PE-backed IPO volumes are down big, they haven't gone to zero. Private equity is still doing everything it can to bring cash in the door today... And some investors are going to get burned.

Remember that PE-backed IPOs are hiding tons of debt. These companies are bound to struggle while interest rates remain high.

That's why investors should stay away from anything to do with private equity today.

Regards,

Joel Litman

Editor's note: We've seen big swings in U.S. stocks this year. But if you know where to look, there is opportunity. This week, Joel and his team joined forces with Chaikin Analytics founder Marc Chaikin to discuss what they call "Perfect Stocks"...

With this approach, Joel was able to find winners that soared 5x or more during the turmoil in 2009 and 2020. Their criteria are so strict that only 164 stocks have qualified as "perfect" over the past decade. And as Joel and Marc explained, this approach could be your "financial lifeline" in 2024...

If you don't have a game plan for what they see coming next year, your money could be at risk. So make sure you hear all the details... If you missed their discussion, watch the replay here.

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