Private equity firms are bankrolling the biggest deals announced this year: Silver Lake helped finance the $24.4 billion buyout of Dell (DELL), and 3G Capital teamed up with Warren Buffett’s Berkshire Hathaway (BRK/A) on the $23 billion takeover of H.J. Heinz (HNZ). Yet the dealmaking revival comes too late to resuscitate many buyout shops that have losing records. “There will be some carnage,” says Jay Fewel, a senior investment officer for the $73.5 billion Oregon state pension fund, which has been investing in private equity for more than 30 years. “A lot of folks raised money in the mid-2000s, when it was pretty easy. Now there are probably too many funds out there.”
Private equity firms pool money from investors, including pension plans and endowments, to buy companies, then sell them and return the money with a profit after about 10 years. The firms, which use debt to finance the deals and amplify returns, typically charge an annual management fee equal to 1.5 percent to 2 percent of committed funds and keep 20 percent of the profit from investments. A mid-decade boom in dealmaking helped buyout firms post stellar returns and attract fresh money: From 2006 to 2008 they raised an unprecedented $702 billion. There are 4,500 buyout shops with $3 trillion in assets.
The firms face two problems: putting the remaining money they have to work and attracting capital for future deals. Only about 28 percent of the money raised from 2006 to 2008 has been paid back to investors so far, according to Cambridge Associates, a research and consulting firm. Firms have commitments for $100 billion from investors that must be deployed this year, according to Triago, a Paris-based company that helps private equity firms raise money—a record for commitments set to expire in a single year. If the firms don’t use that so-called dry powder, they lose it.
Private equity fund performance has sagged, most markedly on buyouts completed at the peak. Since 2007 the industry’s median return has been 6 percent a year, far below its historical average of about 13 percent. Notable among the underachievers are many of the multibillion-dollar investment pools raised in the boom by well-known firms including Blackstone Group (BX), TPG Capital, and KKR (KKR). Blackstone’s $21.7 billion fund from 2006 had a 2 percent annualized return as of Dec. 31, according to a Blackstone regulatory filing. TPG’s boom-era funds—an $18.9 billion pool raised in 2008 and a $15.4 billion pool from 2006—were generating annual returns of 2.5 percent and negative 4.9 percent, respectively, as of June 30, according to the California Public Employees’ Retirement System, a TPG investor. KKR’s annual return on its $17.6 billion fund from 2006 was 6.9 percent as of Sept. 30.
The combination of underperformance and the need to raise money has set the stage for a purge, with investors expected to abandon the weakest firms. “The shakeout will be rather massive,” says Antoine Dréan, chairman of Triago. Dréan estimates that as many as one-quarter of private equity managers will see their funding dry up by 2018.
David Rubenstein, co-chief executive officer of Carlyle (CG), has been preparing investors for a future of more modest results. “We do think that private equity returns probably will come down compared to the historic highs we had 10 years ago,” Rubenstein said in a November interview. Carlyle, which produced average returns of about 30 percent a year, excluding fees, during its 25-year history, is now targeting gains of closer to 20 percent, he said.
KKR began seeking about $8 billion for a new fund almost two years ago, less than half the $17.6 billion it raised for its previous fund. The firm said in February that it had secured $7.5 billion and would extend the fundraising to the second half of this year. David Bonderman’s TPG is expected to seek fresh money in 2014, according to a person familiar with the matter. TPG’s two previous funds were dogged by blowups, including an investment it made with KKR in Texas utility Energy Future Holdings.
Larger firms that have diversified into hedge funds and real estate investments have a cushion against the private equity squeeze. Smaller ones are more exposed. J. Christopher Flowers, who raised a $7 billion fund in 2006 to invest in financial-services companies, has delivered a negative 23.3 percent annual return, according to Oregon’s pension fund. The 2011 collapse of MF Global Holdings, a brokerage headed by Jon Corzine, Flowers’s friend and a former Goldman Sachs Group (GS) colleague, cost the fund, J.C. Flowers, almost $48 million. Jordan Robinson, head of investor relations, declined to comment.
Elevation Partners is another prominent firm struggling with subpar returns. Backed by venture capitalist Roger McNamee and pop star Bono, Elevation began in 2004 with a $1.9 billion inaugural fund. By early 2010 bad bets on smartphone maker Palm, magazine publisher Forbes Media, and SDI Media Group, a provider of dubbing and subtitling services, had dropped its annual return to negative 12 percent, according to the Washington State pension fund. Investors that year rejected the firm’s request to extend the fund’s soon-to-expire investment period by a year, which would have kept in place fees on its $500 million of dry powder, according to three people with knowledge of the matter who declined to be identified because the information is private. Paul Kranhold, a spokesman for Elevation Partners, declined to comment.
Unlike hedge funds, whose investors can pull money out at regular intervals, forcing them to shut down after a few bad years, buyout firms die slow deaths. They linger as so-called zombie funds, unable to raise new money but sustained by management fees they earn on unsold holdings. Their ranks include onetime marquee names like Brera Capital Partners, The Cypress Group, and Questor Management, which haven’t raised money in more than a dozen years. Officials at Brera, Cypress, and Questor didn’t return calls seeking comment.
Some industry observers expect investors to concentrate their bets on a handful of larger firms with strong records. That’s partly because many pension funds that have invested with 100 or 150 firms are seeking to cut back to a more manageable number. “A lot of large investors are doing triage on their portfolios,” says Kelly DePonte, a managing director at pension adviser Probitas Partners, citing moves by the country’s two biggest pensions, CalPERS and the California State Teachers’ Retirement system. “Unless you have a distinct advantage and strong track record, you’re at risk of being crowded out.”