Stephen’s Note: We recently invited my friend and bestselling author Jared Dillian to sit down and discuss the bubble forming in the private equity market. If you missed those discussions, here’s Part 1 and Part 2.

Since then, we’ve received messages from readers wanting to know more about why private equity has ballooned into a bubble and the risks it poses to the economy.

Below, Jared shares why this situation is unsustainable…

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Everything is worse because of private equity
By Jared Dillian

Have you noticed that across businesses in a range of industries, prices are higher, and the customer experience is worse? It’s because a huge swath of the economy is now private equity owned.

Dental practices, car washes, laundromats, veterinarians, smoothie joints, restaurants, self-storage units, funeral homes—practically no business has avoided ruination by private equity. To wit, private equity-owned nursing homes have a much higher mortality rate.

There is a lot to say here. The main reason this is happening is because the founder of a business has a different time horizon than a temporary owner of a business.

The founder of a business is long-term greedy (making sure customers are satisfied so they keep coming back again and again). The temporary owner of a business has one objective: squeeze as much profit out of the business as possible before selling it to someone else at a higher valuation.

This means two things: cutting jobs and raising prices, which the private equity people refer to as “efficiency gains.”

Who knows better how to run a restaurant chain? A 62-year-old founder who has been in the business his entire career or a 33-year-old, fleece-vest-wearing Ivy League graduate to whom the business is just an abstraction, numbers in a spreadsheet?

There are real, intangible reasons why founders don’t jack up prices and fire a bunch of people—they care about the customer. PE guys don’t. In fact, they’re not particularly upset if the business fails as long as they get their money out.

Private equity used to be a smart way to take advantage of low interest rates to buy undervalued businesses with stable, predictable cash flows. Now, the cancer has metastasized, and PE has invaded industries with highly cyclical cash flows, or businesses with real-life consequences if things go wrong, like medical care for people and pets.

And don’t get me wrong—I am not one of these “people before profits” progressives. I’d bet that I’m more of a capitalist than you are. But private equity is a perversion of capitalism—treating living, breathing businesses like trading cards. I suppose this will all be over when a private equity firm rolls up a bunch of private equity firms.

It's a Bubble

We are in the midst of a massive investment bubble, but you wouldn’t know it from looking at the stock market. I believe it’s a bubble on par with the financial crisis.

Private equity poses real, systemic risks to the economy, and this is primarily because of the use of leverage. Debt on top of debt on top of debt, used to amplify returns. To err is equities, but to really screw things up takes fixed income.

And now, we are in a position where we depend upon it. Your pension depends upon it. Your university depends upon it. Pension funds and endowments have been gobbling up private equity for years. It’s illiquid, and if there is a real downturn, there is nothing they can do about it.

Endowments have been copycatting David Swensen for years, and now it has reached the point of absurdity. And why not? Why not get returns equal to or greater than the stock market with zero volatility?

Aha! It is the illusion of zero volatility. When the stock market was down 4% on August 5, for sure, private equity was also down 4%. But did PE firms mark down their holdings? Of course not.

Another thing I thought of recently: A private equity fund is not too different from a plain-vanilla stock mutual fund. They are both long-only. In fact, the private equity fund has leverage. And people are paying 2 and 20 for long-only funds with zero liquidity and no way to get out? Madness. People have gone barking mad.

And arguably, these are worse businesses than the S&P 500. You’re going to pay 2 and 20 for someone to buy Quick Quack car wash? I want to repeat myself here: In the old days, a good candidate for a private equity target would be a business with stable, predictable cash flows. There is nothing more cyclical than a car wash.

All It Takes

All it takes is a catalyst. I can imagine a scenario where public markets go down 20% and private equity firms don’t mark down their holdings at all, and then people start asking hard questions.

Then the redemption orders start coming in, and if the PE firms honor them, they will be selling businesses at distressed levels, creating realized losses and actual marks on their portfolios.

Or maybe none of this happens. Maybe we get a mild recession, and the companies in the portfolio just earn their way out of it. Liquidity always finds a way. Leverage is always unwound. I am very, very bearish.

One more thing before I go…

In case you missed my exposé on the hidden risks of private equity, you can access my new (and free) whitepaper, Operation Watchtower, here.

In this report, you’ll learn about the unwinding private equity market and how you can protect yourself from a market shift on par with the Global Financial Crisis.

We have a massive bubble on our hands… but with every crisis comes opportunity. Just click here to get started.

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Stephen here with one more word on my good friend Jared’s Operation Watchtower whitepaper.

You might not know Jared has lived through it all on Wall Street. He was the former head of ETF trading at Lehman from 2001 right up to the collapse in 2008. He saw the early warning signs of the housing bubble and sees similar cracks today in private equity.

Even if you don’t take action to protect your portfolio, you owe it to yourself to read his research on this. Go here to grab the report.