Private equity investors temper return expectations
BERLIN Feb 27 (Reuters) - Private equity investors hoping for outsized profits are facing an awkward truth - investment returns have shrunk and are unlikely to go back to their peak levels.
At private equity's annual global gathering in Berlin this week, investors acknowledged that the asset class looks unlikely to revert to its bumper past payouts, weighed down by modest global economic prospects as well as an influx of funds into the sector creating increased competition for deals.
"It's just too hard to see, with the level of capital out there, the baseline rates and the lack of growth globally, that you will be able to generate the kind of returns that were available in points of time in the past," Howard Searing, director of private markets at pension fund manager Dupont Capital Management, told the SuperReturn conference in Berlin.
Granted, prospective returns from the corporate buyouts that are private equity's stock in trade are still generous set against meagre bond yields and volatile stock markets. It's just that they are less generous than they were.
A rise in leveraged buyout activity mostly in the United States, culminating in the $24.4 billion offer for computer maker Dell Inc backed by private equity firm Silver Lake as well as the company's founder, has seen private equity fund managers spend more of their investors' money on deals.
Financing costs for deals are at historic lows as debt investors chase better returns amid persistently low interest rates, driving up demand for high-yield debt.
This has in turn led to pledges by private equity executives that they will avoid relying on cheap debt, clever financial tricks and the other excesses of the heady days that preceded the financial crisis.
Some acknowledged that private equity's glory days are not coming back, at least not for the sector as a whole.
"If you are wholly dependent on doing conventional buyouts, which today are very competitive with a lot of money around ... frankly it's going to be very difficult to generate traditional private equity returns in the low- to mid-20 percent (range)," said Leon Black, chief executive of buyout firm Apollo Global Management LLC.
"If you and your limited partners (investors) have decided in this low interest-rate environment that low- to mid-teen returns are OK, then maybe there will be a lot of things to do," Black added.
Private equity has established a track record of outperforming other asset classes. The U.S. private equity index compiled by advisory firm Cambridge Associates LLC shows an net internal rate of return (IRR) of 13.7 percent in the 10 years through September 30, 2012, compared with an 8 percent return by the S&P 500 Index.
Yet returns have come down as buyout funds proliferated.
The top-performing 25 percent of U.S. fund managers whose fund launched in 2001 have delivered a net IRR of 36.5 percent; by comparison the net IRR of the top-performing 25 percent of funds launched in 2004, when 66 funds were raised as opposed to 24 funds in 2001, is 13.9 percent, Cambridge Associates said.
"If you look at the private equity world over its 40-year history, the vintages when we as an industry create good returns are when it is toughest to raise capital," said Kurt Björklund, co-managing partner of buyout firm Permira Advisers LLP .
Many private equity funds suffered from overpaying for assets on the back of too much borrowing in the years leading up to the financial crisis of 2008. These funds however have a typical maturity of 10 years, so the jury is still out on their final performance.
To be sure, there are still some private equity funds that deliver net IRRs of over 20 percent. But the industry is coming to terms with return expectations that are unlikely to improve by a new wave in private equity dealmaking.
"I think net returns in the mid- to upper-teens would be a good outcome for most investors, especially when they look at the landscape of what the alternatives are today," said Thomas Haubenstricker, chief executive of Goldpoint Partners, which manages assets for New York Life Insurance Co and other clients.
Private equity investors typically include insurance firms, sovereign wealth funds, university endowments and family offices, but also large public pension funds that turn to the asset class to help them meet their pension liabilities.
Apollo's Black said fund managers who pay 9 times earnings before interest, tax, depreciation and amortization (EBITDA), the average price for U.S. private equity deals currently, make too many assumptions about what has to go well.
Such assumptions include that interest rates will stay low for the next five years, that companies can be sold at the same EBITDA multiple they were bought, and that they can grow these companies faster than the underlying economy.
Apollo has however managed to secure lower valuations in niches such as corporate carve-outs, or buying businesses put on their block by a parent and paying on average only 6 times EBITDA, Black added.
Adding to deal price inflation has been the accumulated capital by private equity firms that they have to spend or return to investors. As of January 2013, North America-focused private equity buyout funds had $189.4 billion in unspent capital, down just 12 percent from December 2011, according to market research firm Preqin.
Since private equity saw its best returns when capital was scarce, it should become more profitable as investors refuse to stump up more capital for managers who underperform, Permira's Björklund noted.
"A number of the large funds have come down in size now so we would expect to see returns improving," Björklund said.
One way investors have been trying to boost private equity returns is by avoiding fees, either by co-investing with fund managers in companies or excluding fund managers completely and investing directly.
"Returns are absolutely more attractive in the co-investment and direct investment portfolio," said Rich Hall, head of private equity at Teacher Retirement System of Texas. "We are seeing about an 8 or 9 percent advantage relevant to our funds portfolio," he added, referring to the outperformance of such investments.