Investors in private equity are not getting enough money back from prior private equity investments to fund the capital calls for new funds — and the mismatch is staggering. Since 2018, capital calls have exceeded distributions to investors by $1.5 trillion, according to Morgan Stanley.
Distributions are currently running 50 percent below normal. The problem is so severe that some investors and management teams are calling “DPI” — which stands for distributions to paid in capital — “the new IRR,” the key metric for benchmark fund performance, Morgan Stanley analysts said in a new research report on publicly traded private equity firms.
The gap shows there is “a breakdown in the private equity machine, not a temporary dislocation,” said Dan Rasmussen, the founder of asset manager Verdad.
“LPs' confidence in managers' ability to achieve performance metrics is eroding,” the Morgan Stanley analysts said. Investors’ illiquid capital is tied up in old vintages, hampering their ability to invest in new funds. The 2021 vintage funds are the worst of the lot over the past 20 years, according to the analysts. They noted that distributions for that vintage are approximately 80 percent below normal for this point in the vintage curve.
That is not too surprising as that money was raised at the top of the market, before interest rates rose and the stock market turned down in 2022. “The 2021 vintage was priced for perfection; perfection didn’t show up,” said Rasmussen.
But the 2019 and 2020 vintages are also having trouble. Distributions for the 2019 vintages are 40 percent below normal, while those for the 2020 vintages are 30 percent below.
“The breakdown in distributions suggests that there's a systematic problem with the marks,” Rasmussen said. “If you’re trying to sell a house and nobody’s buying, the problem isn’t the ‘exit environment’ — it’s that your price is far above the market clearing level. Same with PE. Valuations need to meet reality.”
Rasmussen added that “because a large share of exits are sponsor-to-sponsor, weak fundraising makes the exit environment worse — creating a vicious cycle. Inventory is piling up — nearly eight years’ worth at current exit rates. That’s not a pipeline; it’s a parking lot.”
Morgan Stanley analysts said that if the trend continues, it could start to hurt the firms’ earnings. “If the lackluster capital markets and exit environment persists and continues to exert pressure on institutional fundraising, we see a risk that the market could start questioning the achievability of double-digit [fee-paying assets under management] growth rates through 2030, calling earnings growth into question.”
They noted that the alternative asset managers Morgan Stanley covers are sitting on more than $950 billion in dry powder, or 25 percent of their assets under management. There is $4 trillion in dry powder across the entire industry. Buyout funds have the most money waiting to be invested, with 46 percent of the total $4 trillion. Of the firms Morgan Stanley covers, Ares has the greatest percentage of its total capital in dry powder, at 26 percent of AUM, followed by TPG, with 23 percent. Apollo has the least of the group, with only 8 percent of its AUM in dry powder.
The Morgan Stanley analysts said that the time needed to deploy that money has gone up to 3.5 years from a historical average of 2.6 years. But at the same time, they note that distributions are cyclical and may have hit their trough.
Others are skeptical. Echoing some of the concerns expressed by Rasmussen, Orso Partners’ Scott Matagrano said that there is “unfortunately, no acknowledgment of the valuations paid for these problematic vintages, issues with increasing sponsor to sponsor transactions, risks with the refinancing walls many of these portfolio companies will hit, and the fact that LPs are apparently starting to prefer private credit given its higher place in the capital structure.”
He added that credit could also be a way “to get ahead of all the inevitable bankruptcies and restructurings of a substantial percentage of the PE portfolio companies.”
