A Case Against Private Equity Investing

Private equity is investing in companies that aren’t publicly-traded. Many pension funds and endowments have allocations to private equity, though the Fairfax County fund I’ve been affiliated with doesn’t. There are good reasons we aren’t in private equity. This article does a good job explaining them. I mention this because the latest wrinkle in private equity investing is to make it available to individual investors through exchange-trade funds and other vehicles.

These levels of leverage leave companies with no margin of safety. Most companies’ cash flows are too volatile and unpredictable to sustain high debt levels for long. In addition, the recent tax reform caps interest deductibility at 30 percent of ebitda, which for most firms translates to about 5x ebitda of debt. This will be particularly problematic for highly leveraged firms, especially in any downturn when ebitda declines. Those that are lucky enough to grow will be fine, but companies with large interest payments and looming debt maturities cannot invest for growth.

The history of financial markets echoes with a warning: beware markets where investors are not only bullish but also borrowers. Yet there is always a logic behind each bubble, a set of ideas that form the foundation of the consensus thinking.