BERLIN Feb 27 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
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
"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,"
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
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
"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
"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