The Growing Crisis in Private Equity: Exits, Valuations, and the Push into 401(k)s

Patrick Boyle

Private Equity Underperforms Amidst Push into 401(k)s [00:00:00]

• Executive Order and 401(k) Access [00:00:00]
  • President Trump signed an executive order allowing private equity firms to access America's 401(k) system.

    

  • The stated goal was to democratize access for smaller investors, enabling them to invest like pension and sovereign wealth funds.
• Underperformance of Publicly Listed PE Firms [00:00:25]
  • Despite the potential for new capital from 401(k)s, shares of publicly listed private equity firms have underperformed the broader stock market.

    

  • The GLPE index is down nearly 10% year-to-date, with major firms like Apollo and Blue Owl down over 20%.

    

  • This underperformance may partly reflect an overhang from a prior rally before S&P 500 inclusion.

    

• Challenges in Exiting Investments [00:01:31]
  • Private equity firms are struggling to sell prior investments at attractive prices, leading to a slowdown in distributions to investors.

    

  • Without successful exits and distributions, raising new capital becomes significantly harder.
  • The industry's "flywheel" of raising, deploying, exiting, distributing, and repeating is not functioning as it used to.
• The Search for New Investors [00:01:50]
  • The push into 401(k)s is seen as a way to find new investors due to frustration among existing ones.

The Disconnect Between PE and the Broader Market [00:02:01]

• Market Dynamics and PE Holdings [00:02:01]
  • The S&P 500's 14% gain this year is concentrated in a few tech giants (e.g., "Magnificent Seven") which exhibit strong earnings growth, cash flow, and less leverage.

    

    

  • Private equity typically invests in smaller businesses, often in slower-growing sectors, with higher debt levels.

    

  • These companies are akin to leveraged small-cap value stocks, a market segment that has been lagging.

    

• IPO Market Stagnation [00:03:16]
  • The IPO market has been dormant, and public investors are not interested in the slow-growth, heavily indebted businesses that private equity holds.

    

• Benchmarking Challenges [00:03:42]
  • Benchmarking private equity against the S&P 500 is problematic due to differences in company size, cyclicality, and leverage.
  • A more accurate comparison would be leveraged small-cap value stocks, but private equity funds charge much higher fees (2 and 20).

The Nature of Private Equity Returns [00:04:09]

• Leverage as the Primary Driver [00:04:09]
  • Private equity is primarily a structure, with most capital deployed through buyout funds using a mix of equity and debt.
  • Debt, typically 60-75% of a deal's financing, is the main driver of returns, amplifying gains but also increasing fragility.
• The Myth of Operational Alpha [00:07:30]
  • Private equity firms promote a narrative of "operational alpha," transforming underperforming companies through operational excellence.
  • However, margin expansion from operational improvements rarely materializes. Bain's 2025 report shows margin growth contributed only 6% to value creation in software over the last decade.

    

  • In carve-out transactions, margin improvement has fallen from 29% pre-2012 to 2% recently.
• Misleading Performance Metrics (IRR) [00:09:40]
  • The industry's preferred metric, "since-inception IRR," is highly sensitive to cash flow timing and can be manipulated.

    

  • Warren Buffett criticized this, noting that IRR calculations often exclude the cost of idle cash held by investors.

    

  • Tactics like delaying capital calls and using short-term loans can artificially inflate IRR, making a fund appear to deliver higher returns than investors actually receive.

The Illusion of Stability and Liquidity Maneuvers [00:11:04]

• Stale Pricing and Volatility Laundering [00:11:04]
  • Private equity projects an image of stability with smooth, upward-sloping returns, but this is often due to "stale pricing."

    

  • Private assets are not marked to market daily but are appraised periodically, sometimes by the fund managers themselves, creating an illusion of low volatility.
  • This "volatility laundering" appeals to institutional investors, but it obscures true risk and underperformance.
• Liquidity Challenges and Financial Maneuvers [00:15:36]
  • The industry is struggling to convert paper gains into actual cash, with over $3.6 trillion in unsold companies.
  • Distributions as a percentage of net asset value have fallen to 11%, the lowest in over a decade.
  • With the IPO market comatose and strategic buyers cautious, PE firms resort to "continuation funds," "secondaries," and "NAV loans" to generate liquidity.
  • Continuation funds allow a PE firm to sell an asset from one fund to another it manages, resetting the clock and creating a paper gain without a true exit.

    

  • Secondary market discounts (15% or more) indicate the true value investors place on these assets.
• First Brands Collapse as a Warning [00:16:51]
  • The collapse of First Brands, which borrowed heavily and used opaque financing, illustrates the system's fragility.

    

    

  • Its failure led to $2.3 billion in vanished assets, highlighting risks in private credit.

    

Social and Regulatory Concerns [00:21:02]

• Impact on Society [00:21:02]
  • Beyond financial performance, private equity faces criticism for its social impact, where the goal often becomes wealth extraction rather than growth or customer focus.
  • Congressional investigations into PE-owned dental chains revealed practices that prioritized profit over patient care, leading to unnecessary procedures.

    

  • The pursuit of EBITDA growth can result in negative outcomes like understaffed care homes and hollowed-out retailers.
• Antitrust Issues with Roll-up Strategies [00:21:54]
  • Private equity's "roll-up" strategies, where many small businesses in fragmented industries (e.g., doctors' offices) are consolidated, raise antitrust concerns.
  • This consolidation can reduce competition and lead to higher consumer costs.

The End of Cheap Debt and a Fragile Future [00:22:17]

• Higher Interest Rates Impact [00:22:17]
  • Private equity thrived on cheap debt in a falling interest rate environment, a tailwind that is now gone.
  • Higher interest rates significantly increase financing costs, reduce valuations, and lead to fewer exits.
  • Many PE-backed companies are highly indebted (6-8 times EBITDA), which increases bankruptcy risk as rates rise.
• Uncertainty and Shrinking Returns [00:23:13]
  • Inflation, tariffs, and policy uncertainty make underwriting new deals difficult, particularly for smaller businesses.
  • The industry's pitch of diversification, excess returns, and stability is being challenged by high fees, uncertain exits, and shrinking returns.
  • The expansion into 401(k)s, despite sophisticated repackaging, presents retail investors with high fees, long lockups, and limited transparency, potentially selling them a "bug" instead of a "feature."

    

    

    

    

    

    

  • Ultimately, private equity needs real exits and distributions to prove its value, rather than relying on flattering presentations and accounting maneuvers.