Software losses could leave private equity unable to refinance

Transcript

Transcribed by machine (Whisper) from the episode’s audio, so a word may be off here and there.

1. 33:29

   So the problem, there's private equity and there's private credit. And private credit lends money to private equity to buy companies. That's like the universe. Sure. What makes it incestuous is that a lot of private credit funds are owned by private equity. Right. So, you know, this is an example. The largest private credit fund, which is like $80 billion, is called B-Cred. B-Cred is owned by Blackstone.

2. 34:01

   Blackstone is the largest. private equity firm in the country. So it makes it a little incestuous. But what's happened, you know, like if you wanted to ask, you're like, there are two major problems. The first problem is private equity bought a ton of stuff. Yeah. Software. What kind of comes to software? I'm just speaking generically, you know, when rates were nothing. And then they levered the little puppy up. And historically, Historically, like if you were an investor in a private equity fund, you would put your money in and then they'd run the company for a while.

3. 34:38

   And then three or four years later, they would sell it, all the companies, and you'd get all your money back, plus profit. Nice. This is great. Sounds great. Count me in. Count me in. So now three to four years has become seven. Not so great. Yeah. It's become seven because rates are a lot higher, and these companies are all levered up, and they're levered up mostly with variable rate debt. So the debt interest rate has already gone up.

4. 35:05

   Right. It's variable. And correct me if I'm wrong, if I come to you and say, I don't want to wait anymore, I want my money back, you say no. Too bad. There's a gate up now. Well, the gate is for these funds that are public for retail. And there you're only allowed to pull out 5% of the total amount per quarter. If you're an institution, too bad. Just too bad. You're a big boy. You knew what you got into.

5. 35:32

   You knew what you got into. Sorry. I'm curious if you can bring some clarity to this for me. So in the situation that you're describing, where people can get paid out this 5%, I have a friend who used to work at the Fed, and he works on his PhD now, and he studies private credit. And he was trying to explain a problem to me where a lot of private credit right now will pay. They are taking on more loans to make these payments to their holders in the short term, but are not disclosing the value of the underlying assets as they are likely falling right now.

6. 36:10

   But because they're private, they don't have to disclose that information. And it seems like they're sitting on some sort of larger bubble here and this is me poorly explaining what he explained to me and i was wondering if you understand you're allowed to take on a certain amount of leverage yeah when you're a private credit fund so generally it's two to one yeah but let's say you're not two to one let's say you're one and a half to one So let's say you get a redemption.

7. 36:35

   Now, a lot of the redemptions were like 10%, 15% of the entire value of the fund. But the contract says, we only are required to give you up to five. Okay, so now we got to give you five. So now we have a choice. Do we go out and sell a loan? We got to find the money somewhere. It's not like, you know, it's sitting around. At least you own our liquid, right? You made the loans already. So do we go out and sell a loan?

8. 37:10

   And chances are, given that rates are higher and maybe it's software, that we would take a loss and we haven't marked the thing down. And now we're going to take a real mark and we don't want to do that. Or do we lever the fund from 1.5 to 1.6 and pay people that amount of money? Oh, I see. So you still technically working within the law. Like, you have room for flexibility. Right. You aren't going over that cap.

9. 37:35

   You're just taking on a little more risk in order to not take the loss on the books in the short term. Correct. All right. The big problem with private credit and private equity, we're going to come to that. Okay, I really want to ask about that. We've had that on the podcast, too. That's okay. But let me just finish with private credit. Yeah, yeah. A lot of their stuff is software. And then, you know, there's what's called the SaaSpocalypse.

10. 37:59

    Have you heard that? Yeah, we did an episode. They're all about Wix and Monday and Adobe. Oh, yeah, yeah. All those companies are now. So all these companies, you know, other than cybersecurity companies, all these software companies are down like 50%. So if you go back, most of these software buyouts were done between like 2018 and 2022. And they did half equity, half debt. So simple math. if, you know, take Adobe.

11. 38:31

    Adobe is down 60% from the peak. I mean, Adobe is a great company. It's down 60% from the peak. I mean, it's insanity. So, and, you know, people are petrified. The AI is going to destroy Adobe. I mean, I'm not an expert. What the hell do I know? Well, I'll tell you. I want to jump in. I tried the AI clone of Adobe. Oh, did you really? Because I mentioned it. How was it? I use it for my thumbnails.

12. 38:52

    Was it good? There's no different. I could not tell a difference. I think. See, I mentioned it on my podcast And I said, this guy came out with a free version. I said, I don't know. know how good it is, but free is free. Yeah. And again, I'm not a deep, deep user of the niche. Most people aren't. But I use it for my thumbnails. It's going to be good enough for 95% of people. Good enough. And that was spooky. They made all of their software.

13. 39:16

    So mathematically, if let's say, hypothetically, almost all these companies are down 50%. If it's half equity and half debt, the debt only goes down after the equity has gone to zero. Well, now the equity is worthless. Think of it this way. A billion dollar deal, 500 million in debt, 500 million in equity. And let's say the value of the company is now only 500 million dollars. The debt doesn't go down a dollar until equity goes to nothing.

14. 39:46

    Then it goes down. So if the value of the company is 500, if the enterprise value is 500 million dollars, the debt's worth 500 million and the equity's worth zero. So now all these companies are going to start to refinance starting next year. So imagine the conversation. Well, the variable rate, they're there already. But just imagine the conversation. So private credit says to private equity, your equity is worthless.

15. 40:11

    If you want to refinance, you need to put another $500 million. And private equity says, screw you. We walk. And that's what I think is going to happen. So these private equity portfolios are going to be awful.