Invasive Ants, Hunting Lions, and the Future of Private Equity

During their latest episode of the VALUE: After Hours Podcast, Carlisle, Taylor, and John Rotonti Jr discussed Invasive Ants, Hunting Lions, and the Future of Private Equity. Here’s an excerpt from the episode:

Jake: All right. So, this is called ants and lions hunting and private equity. So, we’ll see if we can turn this all into making any sense out of. So, first, a shoutout to my man, George, for sending me this delicious little veggies prompt from a– It’s from a scientific American little piece that’s titled These Invasive Ants Are Changing How Lions Hunt.

So, we’ll start out with the idea that regularly, almost every year at the AGMs, Mr. Buffett will say that, “In economics, you always have to ask yourself, And then what?” And the same is true for another complex adaptive system, which is mother nature. We’re going to follow a series of and then what’s, and we’ll see where it goes. And then we’ll see if we can draw some lessons back to business in investing.

So, researchers were exploring a regional ecosystem in Kenya, Africa. There were these ants that were indigenous to that region. They were fierce defenders of these local acacia trees. So, when an elephant would come to graze on the tree, for instance, or trample it over, the ants would swarm the elephant and crawl up inside of its nine-foot nose and use their mandibles to pinch inside the elephant.

Tobias: Oh, man.

Jake: Yeah, it’s rather unpleasant, I imagine. And as a result of these ants, the elephants would largely leave these trees alone. It’s not worth it, right? And then, it’s really not worth going and getting like ant neti pot every time you [chuckles] try to eat a leaf off of a tree. So, these indigenous ants had long protected, and their own living home in this symbiotic relationship.

Well, recently, researchers found a new invasive species of ant has moved in, and they’re killing off the local indigenous acacia ants. These invasive ants are actually smaller than the acacia ants, but they’ll team up and they’ll hold the acacia ants down by their limbs, and then basically draw and quarter them. They’ll dismember the ant, which mother nature is not messing around.

So, in not too long after, the new ants are displacing the old ants. And shortly thereafter, herbivores have figured out that these acacia trees aren’t being protected by these tiny protectors, and especially the elephants, who do a lot of damage rather quickly. So, the tree population, of course, has started to decline. And with that less tree cover then, we’re going again, these series of and then what’s, with less tree cover, the zebras are more safe because less trees make it harder for a lion to ambush an unsuspecting zebra and make them their lunch.

And then what? What are the lions doing now that they can’t eat zebras as readily? Well, it turns out they’ve shifted to hunting buffalo more, only that’s a lot tougher and more dangerous for the lions because the buffalo is twice as massive as the zebra and they have a much better defense against lions. Like, there’s videos online of these buffaloes, like, chucking a 400-pound lion into the air to fend off attacks. And of course, the lions are at least moderately successful, so the buffalo population is suffering now.

And so, this is like a classic butterfly effect, right? You disturb one little, small seemingly inconsequential thing, in this case, a tiny, invasive species of ant, and you get this cascading effects where they lead to an eventual decrease in a buffalo population, 10 links down the chain. So, the first lesson, I think, is that it’s fiendishly difficult to predict all of these complex interactions.

And so, it is with economics. No matter how much modeling expertise you have, how much modeling you do, it’s impossible to predict, I think, how shifting– Let’s say interest rates, for instance, how they ooze their way into every crevice of the economy and what will manifest because of these changes. So now we’re going to shift to talking about private equity and see if we can draw some parallels to our and then what exercise.

So, Bain & Company came out with a recent report on all things private equity. And this was flagged by a friend of the show, Dan Rasmussen. So, in 2023, the deal value fell by 37% from the year before, and exit value slid by 44%, so almost half as much. And things are not very much like they were in the go-go years of 2021. And today, nearly half of all global buyout companies have been held for at least four years. So, there’s $3.2 trillion of aging, un-exited company value on PE’s balance sheet right now. And just for context, that was like $1 trillion in 2016.

And of course, there’s a lot of discretion around how you mark these assets. Like, good firms are still– they’re clear about their valuation policies to their LPs and are appropriately conservative. But of course, I think that Cliff Asness would agree that volatility laundering is still alive and well in the PE industry.

If you think about it just from an incentive standpoint, like, why if you were a PE firm would you want to show bad results? And also, if you’re one of these big pools of capital, like an endowment, why would you want to hear bad results if it’s possible that they might smooth themselves away over time? Of course, just don’t tell me, if it’s going to end up being better later. So, I’m left wondering to whom will private equity exit these $3.2 trillion worth of businesses to? Themselves, each other, public markets? The IPO window is a bit frosty lately.

And then the FT Alphaville, if you guys follow and read that, but they said that PE is sitting on an astonishing $2.6 trillion of capital it’ll eventually have to deploy. So, public companies tend to borrow in long-term and fixed, and private equity tends to borrow short and floating rate. And they’re often borrowing in private credit markets rather than issuing bonds like a public company would. And so, the median sponsor backed company saw their borrowing rates already move from 4.9% in 2022 to 7.2% in 2023. Whereas the median S&P 500 borrower only moved from 3.2% to 3.7. So, the S&P has hardly even noticed that rates have gone up relative to private equity, which has really seen them gone up, really seen them increase. So, for PE, basically what was once cheap debt isn’t cheap anymore.

And then what about valuations? This is another issue that have been talked about. Private equities closed transactions at 13.8% EV to EBITDA in 2021 and 2022. That number used to be more like five times rather than-

Tobias: Ouch.

Jake: -13 times when David Swensen was putting up awesome returns at Yale by tipping towards privates. So, from reference, from 1990 to 2010, private equity returned 14.4% per year, compared to 8.1% for the S&P 500. And that 6%, roughly outperformance, was net of private equity’s 2 and 20 free structure. So, that means the gross return was really more like 20% a year for that kind of heyday. But there’s a feeling that a lot of this compounding is stalling. And last year, revenues for PE firms were actually slower growing than the S&P 500, 4% versus 5%. PE backed firms generally have lower margins than public companies, so the rise interest costs have meant that the median PE backed firm now is actually generating zero free cash flow. All the margin has basically shrunk and been absorbed by debt servicing.

So, after 40 years of declining rates, in our analogy, like maybe these were sort of the ants that were protecting the acacia trees, perhaps the fed elephant has removed the tree cover, and these lions are going to have a much more difficult time finding juicy zebras to feast upon. So, with this more expensive debt, perhaps a less target rich opportunity set higher valuations, too much money chasing too few assets, I personally find it a little hard to be as bullish on the prospects for most of private equity. And of course, I’m sure there are exceptions of people doing smart things. There always are.

So, perhaps they might be forced to hunt more dangerous beasts like buffalo and are more likely than to suffer resulting injuries. And in general, whether it’s mother nature or finance, you got to be careful of these small, seemingly inconsequential changes, because they can lead to rather consequential consequences that just propagate throughout a system.

Tobias: Good one, JT.

John: That was excellent. Some good connections there.

Tobias: That private equity model is one way of converting that platinum growth fixed PE stock that’s doing all the buybacks. It’s a way of turning that into equity appreciation, because you’re using the cash flows to pay down the debt and your equity, assuming that the enterprise value is staying steady, your equity should be going up as the debt comes down.

Jake: Yeah. How do you become a billionaire in private equity? Borrow a billion dollars and pay it back.

[laughter]

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