Beware of "zombies" on your investment lawn! Here's how to avoid them…

From the desk of Miles Everson: Welcome to today’s “The Independent Investor!” I hope you’re all having a great midweek. Today, I’m excited to talk to you about another important investment insight. In these articles, my goal is to help you apply these strategies so you can experience financial freedom and achieve financial stability in the long run. Ready for today’s topic? If so, I encourage you to keep reading below to know more about it!

Beware of "zombies" on your investment lawn! Here's how to avoid them… If there’s one thing you need to know about private equity (PE), it’s this: PE firms never meant to run “forever funds.” Depending on how big these firms are, they may run several investment funds at once and launch several new ones each year. Here’s the thing: The typical life cycle for one of these funds is supposed to be somewhere between seven and 15 years. It goes like this… A PE firm will raise cash from investors to put into new funds. Then, over the next seven to 15 years, the fund will do its best to buy cheap companies with debt, fix up their operations, and sell those businesses either to other PE firms or via the stock market. Once all the companies are sold, the PE firm will “retire” that fund, return cash to its investors, and start working on a new fund (as we’ve said, these aren’t “forever funds”). BUT! Recently, that game plan isn’t working as it’s supposed to… PE firms are struggling to offload their funds’ investments. That’s a BIG problem for both private AND public investors. When the “Game Plan” is No Longer Working According to Professor Joel Litman, Chairman and CEO of Valens Research and Chief Investment Strategist of Altimetry Financial Research, PE firms have been struggling to wind down their funds recently. Usually, these firms have two options to sell their portfolio companies: The first option is to sell to another PE firm. As mentioned earlier, PE firms often spend a few years fixing up a business’ operations and making the company more efficient. Such a business becomes more attractive for larger firms that otherwise wouldn’t have looked in its direction. The problem is, this option has become much less appealing since interest rates started rising. The reason for that? PE firms usually buy companies with debt to increase their returns… and with interest rates above 5%, it’s become harder for these deals to make money. The second option is to sell the company in an initial public offering (IPO). This is an important mechanism for PE. Without it, PE firms would be stuck selling the same businesses to each other forever. After a PE firm fixes up its portfolio companies, it can get a new group of investors in on the action via an IPO. Even better, these deals don’t require boatloads of new debt. Professor Litman says in 2021, PE-backed IPO volume reached an all-time high of nearly USD 140 billion. However, in recent times, volumes have plummeted to their lowest levels since the Great Recession. That’s because recent PE-backed IPOs have mostly flopped. Professor Litman states while the process of going public doesn’t add debt to these companies, PE-backed companies still tend to carry lots of debt. That makes public investors nervous with soaring interest rates! For example: PE firm Permira took shoe company Dr. Martens public in January 2021. Its stock is down roughly 80% since then. Then, in September 2021, payment-software company EngageSmart was taken public by General Atlantic. Its stock is down more than 30% since then. Judging from these two examples, that’s a bad look for the PE business model. This year, PE-backed IPO volumes are on track to be less than USD 20 billion. In fact, it’s gotten sooooo bad that PE firms have started buying back their failed IPOs. They’re hoping that taking the companies private again will allow them to find a better way to make some money. The thing is, the damage has already been done. It’s clear that PE firms are failing at their game plan… and that’s going to make it harder for them to sell in the future. What’s worse? More PE firms are entering “zombie” status. This means they can’t close old funds and start new ones. Oh no… — According to Professor Litman, while PE-backed IPO volumes are down BIG, they haven’t gone to zero. PE is still doing everything it can to bring cash in the door… sadly, it’s inevitable that some investors are going to get burned. Remember: PE-backed IPOs are hiding TONS of debt. These companies are bound to struggle as long as interest rates remain high. The bottom line? If you’re an investor, you should keep away from anything to do with private equity for the meantime. Hope you’ve found this week’s insights interesting and helpful. SPECIAL ANNOUNCEMENT: Hi! As you may have noticed, I often mention my friend and colleague, Professor Joel Litman. Thousands of investors worldwide (including most of the best ones) rely on Professor Litman’s unique approach to investment research and his firm’s Uniform Accounting database. Though Joel spends much of his time advising the big investment firms and some of the largest US businesses, he believes, as I do, in the power of independent decision making when it comes to personal finance. For those Freebirds among us who make our own investment decisions, Joel and his team have created a fantastic tool: The Altimeter. Lately, as competing forces of excitement around AI, fears of economic downturn, and uncertainty about Fed policies have wreaked havoc on the market, I’ve leaned on Joel’s steady advice and data-driven approach to investment research more and more. This is where the Altimeter comes in. Professor Litman and his team designed this tool to show you the true value, profitability, and outlook of over 6,000 companies in their database. Information about the companies in their database is updated in real time so you can make informed and up-to-date decisions about your stock picks and portfolio. In today’s volatile market, the Altimeter is the most trustworthy and reliable way to optimize your portfolios. If you’re not familiar with Joel’s approach to research and the incredible tool he’s built around it, take a look here.     Stay tuned for next Wednesday’s The Independent Investor! It seems the artificial intelligence (AI) boom has started to wane, leaving investors worried as they wonder if the peak in this space is already over. Learn more about why investors haven’t bought up all the AI players yet in next week’s article!