Stocks Aren't Safe From the 'Zombies' in Private Equity

Editor's note: Most investors don't think much about private equity... But this market can still affect your money. Today, we're taking a break from our usual Weekend Edition fare to share a warning from Rob Spivey (of our corporate affiliate Altimetry). In this piece – adapted from a recent issue of the Altimetry Daily Authority e-letter – he covers why "dead money" in this space is a problem for everyone... and why now is a good time to diversify.

"Zombies" are taking over... but you might not even realize it.

That's because it's happening in private equity ("PE"). Private-equity investing is when big firms – and some accredited investors – look for opportunities that most of us can't take advantage of... outside the public stock market.

These folks take ownership stakes in private companies... usually with the goal of restructuring those businesses and reselling for a profit.

But today, the $12 trillion PE industry is full of dead money.

Interest rates are elevated. So these zombie PE firms can't afford the interest on their debt... making them the "walking dead" of the investment world.

Zombies had been popping up in PE long before interest rates started rising, though. Take Fenway Partners, for instance. The firm hasn't raised money since 2006... And its portfolio still looks the same as it did all those years ago.

In short, not every PE firm can be a giant like Blackstone or Carlyle. Ten of the biggest pension funds have nearly $7 billion stuck in PE firms that are at least 15 years old... And they're tired of waiting around for a payout.

Many pension funds will have to cut their losses and pull their investments out. Even if they decide to wait a little longer, they'll likely think twice before putting even more money to work in PE.

And if you think this problem will be contained to the private market... think again.

Today, I'll explain why these zombies might not be around for much longer – and what it could mean for your stock investments.

PE firms can't keep feasting on cheap debt...

If they want to stay afloat, they'll need to turn to fundraising. As we mentioned, there are tons of zombies that haven't raised money in 15-plus years.

Even worse, just as they want to raise money... nobody wants to invest. PE investments rely on debt to be profitable. And the more expensive that debt is, the harder it is to get the high returns people expect.

With today's high interest rates, it's a bad time to be a PE zombie looking for cash.

Management-consulting firm Bain & Company expects a 28% decline in industrywide fundraising this year. Said another way, investors are funneling nearly a third less money into PE than they did in 2022.

And that's leading to the worst-case scenario... bankruptcy.

Through the first half of the year, the PE market reported 54 bankruptcies. That's more in six months than we'd see in most full years. Take a look...

If this rate keeps up for the rest of the year, we'll see upward of 108 bankruptcies. That's at least a 13-year record... even higher than at the height of the pandemic.

But while these bankruptcies are happening in private equity, it doesn't mean the public market is safe...

PE firms are still customers and suppliers of publicly traded companies. These bankruptcies can't be neatly contained.

Plus, PE zombies might need to liquidate other assets to cover their losses. And that's a big problem...

You see, private firms don't need to report losses unless they sell an asset. So when they're forced to sell, the sudden drop is jarring. It can look like asset prices are falling faster than they actually are. That can spook investors into selling stocks, too.

And it's yet another reason banks might keep tightening their lending standards.

At the end of the day, PE-backed companies are still a part of the same economic web as the rest of the economy. So even though bankruptcies are happening in PE today, the trend is going to keep spreading.

The Federal Reserve is already trying to steer us into a recession. And the PE landscape makes it even clearer that we should be cautious about the equity markets – both private and public – right now.

If your entire portfolio is invested in equities today, your wealth could be at serious risk. Be selective and diversify.


Rob Spivey

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