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Private equity can't just hide out in a wooded bungalow

IF EXCHANGE-TRADED funds are the fast food of investing, then private equity is the private kitchen. As the world spirals into a recession and the coronavirus pandemic batters your retirement accounts, wealthy investors who bought into assets from unicorns to paintings can hide in an elite bubble that isn't subject to brutal mark-to-market fair value write-downs.

But once in a while, a high-profile unicorn hunter can blow the lid off that opaque world, giving us a glimpse of just how much pain private equity is in. Sometimes, private kitchens churn out terrible dishes, too.

Investors are fleeing as SoftBank Group Corp., which runs the US$100 billion Vision Fund, scrambles to shore up its balance sheet, as well as those of its portfolio companies.

SoftBank gives a good feel for the landscape, because it behaves more like a private equity firm than an angel investor: Its capital is really debt, and it likes to invest in rivals and force them to merge.

SoftBank is seeking to raise billions to support its unicorns battered by the coronavirus outbreak, saving those that still show potential and cutting loose the ones that bleed too much cash. On the one hand, it's in talks to lead a fresh US$100 million funding round for Plenty Inc., perhaps because the indoor farming startup can benefit from panic buying of fresh produce. On the other, OneWeb, a satellite operator, has filed for bankruptcy.

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SoftBank's desperate scramble must resonate with many private equity firms out there, whose portfolio companies will inevitably need their patrons' help. By early March, industry titans Blackstone Group Inc. and Carlyle Group Inc. had already urged businesses they've invested in to do whatever it takes to stave off a credit crunch.

But with blue chips drawing at least US$124 billion from their credit lines in the first three weeks of March, and dollar funding this tight, will lenders have the bandwidth to aid smaller companies? Banks certainly have much bigger deals to digest: They'll need to come up with US$23 billion of loans soon for T-Mobile USA Inc. to close its merger with Sprint Corp.

Granted, for private equity firms, cash levels are at a record high. Last year, capital committed to this sector grew 20 per cent to US$1.3 trillion, estimates Pitchbook, a Morningstar company.

But instead of buying new assets, firms may have to earmark a good chunk of that money for existing investments, either recapitalising - like what Softbank has done for basket case WeWork - or leading unplanned funding rounds.

Meanwhile, making capital calls to investors can't be much fun right now. Even the best of them - pension funds and sovereign wealth funds - are dealing with their own crises and may not want to pick up your calls right away, especially if it means selling other assets at deep discounts just to come up with your money. Plus, we now all have the convenient excuse of working from home: Some of us are hiding in the woods (or the Hamptons), away from the raging virus, and may not have good cellphone reception.

Just look at SoftBank. As of December, only about 75 per cent of the Vision Fund's committed capital is with the fund, and the company still needs to call US$17.5 billion from third-party investors, its latest filing shows. Since then, Saudi Arabia, a major investor, has started an oil price war, further diminishing its fiscal power.

So forget about Vision Fund 2; founder Masayoshi Son needs to fill up 1.0 first. In the last decade, private equity firms piled vast amount of debt onto their portfolio companies to boost returns. More than 75 per cent of deals in the sector included debt multiples greater than six times Ebitda in 2019, compared with 25 per cent after the collapse of Lehman Brothers Holdings Inc., according to Pitchbook. When liquidity recedes, these investments are in trouble.

To make matters worse, portfolio companies' ability to service debt is even worse than it looks on paper, because Wall Street lawyers and bankers often juice earnings to make purchase prices look more reasonable and so, underwriters can originate more loans and earn more fees. In 2016, businesses involved in a merger or leveraged buyout missed their own earnings projections by an average of 35 per cent in the first year after the deal, Bloomberg Businessweek reported in December.

So imagine the coronavirus world, where any prior earnings projections feel as outdated as Sex And The City stars prancing around Central Park in Manolo Blahniks. Just as social distancing is becoming the norm, so too will corporate defaults.

The global rate could climb to 16.1 per cent if the pandemic brings economic conditions that mirror the Great Recession, Moody's Investors Services warned last week.

In private equity, fancy terms like total addressable market or adjusted Ebitda are often used to make a company look more profitable than it is. But the coronavirus is unravelling all that. Just like the rest of world, private markets are also suffering. Ray Dalio's "cash is trash" motto is so yesterday. BLOOMBERG

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