• One Hat Research LLC

Private Equity Losses May Be Hiding (and Mounting)

Wall Street banks are losing enormous amounts on debt commitments to leveraged buyouts, commitments they agreed to on the mistaken bet that the Fed would not continue raising rates to fight inflation and on a correlated bet that stock markets would not continue falling. The losses on one deal alone are reported to be $600 million, and that only includes realized losses; unrealized losses on loans the banks were unwilling to sell at market prices may ultimately push that number much higher.

What has gone unreported are the implications of this debt collapse for the private equity firms that put their investors' capital into the deals. In the deal mentioned above, the buyout of Citrix Systems, Inc. by Vista Equity Partners and Elliott Investment Management, the reported bond pricing suggests that the equity invested by the two firms is all or substantially lost already. The value of that equity isn't available in the public market and we do not know how those firms are marking the investments or reporting them to investors, but whatever losses have occurred on the debt, the losses on the equity are likely around that bad or worse.

Things may turn around, of course. We've understood since Black & Scholes [Fischer Black & Myron Scholes, The Pricing of Options and Corporate Liabilities, 81 J. POL. ECON. 637 (1973).] and Merton [Robert C. Merton, On the Pricing of Corporate Debt: The Risk Structure of Interest Rates, 29 J. FIN. 449, 454 (1974)] that the equity in a firm with debt is viewable as a call option on the value of the underlying firm with the debt obligation as the strike price. The Citrix debt isn't due for years. Maybe things will turn out well and today's equity impairment will be tomorrow's big payday. At this point, however, Vista and Elliott are sitting on huge losses.

Something similar is facing many other private equity firms right now.

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