The Money Behind the Private Equity Boom

Low-profile pension funds are funding the historic buyout wave, to pay for the retirement of teachers and other government workers

It isn't even Thanksgiving yet, but private-equity funds already have raised more money than they did in the record-breaking year of 2000. U.S. private-equity firms have raised $177.89 billion so far this year, exceeding the $177.75 billion record of 2000, industry newsletter Dow Jones Private Equity Analyst announced Nov. 3. And fund-raising could end the year at $225 billion, far exceeding the $159 billion raised in all of 2005, the newsletter said.

Ever larger deals are announced regularly, all evidence of a historic boom. HCA, the hospital company, went private this year, in a deal that broke the private-equity buyout record set by KKR's RJR Nabisco takeover in 1988 (see, 9/12/06, "Bidding on Freescale Sets Off Alarms"). Even Bill Gates is getting in on the action: His Cascade investment arm teamed up with Saudi Prince Alwaleed in a $3.7 billion buyout offer for hotel giant Four Seasons (FS) (see, 11/7/06, "Barring the Door at the Four Seasons").

Where's all that money coming from? Even Gates and Alwaleed aren't rich enough to fund all these deals on their own. They need help from investors, known in the industry as limited partners. It's the partners, which include some of the world's largest and most powerful pension funds, that are funding the unprecedented boom in private equity (see, 10/6/06, "Institutional Investors Pouring Cash into Private Equity").

Pension Players

In some cases, these pension funds are making private-equity investments of their own, just as any other buyout fund would. "We've been leaders in private equity since we entered the field 10 years ago. We're there for the return," said Jim Leach, who runs the $6 billion private-equity fund at the Ontario Teachers Pension Plan.

Private equity has been a great investment for OTPP. By owning brands such as Samsonite and the Toronto Maple Leafs, OTPP has achieved private-equity returns of 26% a year, easily beating the return in the public market. The fund also invests in other funds, especially in regions or markets where it has little expertise of its own.

That success has encouraged other pension funds to step up their private-equity activity. The New Jersey Investment Dept. is boosting its private-equity allocation to $4.1 billion for the fiscal year ending June 30, 2007. That's up from $2.2 billion in the fiscal year ended June 30, 2006, according to spokesman Thomas Vince. The California Public Employees' Retirement System, the $220 billion California pension plan, invests 6% of its assets in private equity. That's up from less than 1% at the inception of the program in 1990, according to spokesman Clark McKinley. It has $33 billion in private-equity capital commitments and $12 billion in investments. The private-equity investments have returned more than 18%, McKinley says.

Cashing Out

While pension funds and institutional investors have invested in private equity since the industry was created more than 30 years ago, their interest in the sector has soared during the past year. That's because 2005 was a pivotal year for private equity, which cashed out of well over $100 billion in investments and returned loads of cash to investors, according to John O'Neill, partner with Ernst & Young Transaction Advisory Services.

"It all came together in 2005, and every megafund cashed out of its investment portfolio and distributed cash to limited partners," O'Neill says. That was possible because the companies that private-equity firms had acquired several years before were doing well, and it was easy to sell them or take them public. In many cases, pension funds used the profits taken in 2005, and reinvested them in private equity in 2006.

Private-equity returns don't always exceed the return in the public markets. The top quartile of funds outperform the pubic stock markets. Their returns are typically in the 18% range, although some funds are still achieving returns of 30% or more, industry insiders say. There's no evidence that other private-equity firms, as a group, outperform the public market, according to Jim Leech, senior vice-president of the OTPP private-equity unit.

Big Money

The big private-equity funds and big pension funds are drawn to one another because of the dynamics of the industry. The top quartile of funds tends to include the megafunds, such as Blackstone and Texas Pacific, although smaller funds can do well, too. The players in the top quartile of private-equity funds tend to stay there, unlike the public markets, where the concept that past performance is no guarantee of future profits is accepted as common wisdom.

The big pension funds need to put large chunks of capital to work. It's inefficient for them to make smaller investments. One industry insider who spent years working at state pension funds says it takes just as much time to vet a $40 million deal as it does to vet a $400 million deal. As a result, the big pension funds give money to the proven megafunds that dominate the top quartile of private-equity firms.

As pension funds funnel ever more money into private equity, private-equity funds get bigger and bigger. Blackstone turned heads with a $15 billion fund earlier this year. Now, it's contemplating a $20 billion fund, according to O'Neill. That will make it possible for private equity firms to buy larger and larger companies, according to O'Neill.

Risks and Rewards

Private equity firms have kicked the tires of media giant Vivendi this year, although tax issues have made the deal undoable, industry executives say. That's because Vivendi's tax breaks from the French government won't be transferred to a buyer, those executives add. But the fact that private-equity firms are even considering a $50 billion deal shows how the industry's purchasing power has grown.

Why is private equity so lucrative? The classic approach is to buy a company that generates lots of cash. Then the new owners put more debt on the balance sheet and use the debt to fund the payments of cash dividends to themselves and other equity holders. The strategy can work, as long as the debt levels don't get out of hand and the owners manage to cut costs and improve operations. If all goes well, the new owners can resell the company or take it public again, generating even more profit. If it doesn't go well, the acquired company can go bankrupt (see, 9/7/06, "Selling Out for Buybacks").

There are several reasons why private equity commands a higher profit than the public market. Leech says private-equity players can command a premium over public investors because the perception is that their capital isn't as liquid as public capital. They can't just sell any old time they want. Leech says public investments aren't really that liquid anyway, because big institutional investors would destroy a stock's share price if they tried to sell. Private-equity investors also have an opportunity to dig deeper into the books of a company they're are about to acquire, allowing them to do better due diligence, Leech adds.

Still Booming

The returns are likely to get smaller over time, many experts say. Private-equity firms are competing with one another, forcing up the price of the companies they buy. And as acquisitions get larger, it may be harder to find a buyer a few years down the road. That means a private-equity "exit" may involve a long, slow march toward an IPO.

But even if the returns aren't what they were, they're likely to beat the public market. Cash-rich pension funds have few other options, so they will probably continue to fund the private-equity boom for some time.

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