Private Equity Finds the Easy Money Gone

Hamilton "Tony" E. James, president of Blackstone Group (BX), the world's biggest private equity firm, was in an office park in a Portland (Ore.) suburb last month trying to raise money for a new $13.5 billion buyout fund. Instead of jumping at the opportunity to invest with a premier money manager, members of the Oregon Investment Council, a $52 billion state employees' pension fund, grilled James for almost an hour about the performance of Blackstone's Fund V, launched in 2007. "That all sounds really great, and you probably raised money at the right time so you could go out and get deals," said Katherine J. Durant, one of the council members. "That said, why does Fund V look so bad?"

Durant's skepticism reflects a new era for private equity: A year after the financial crisis subsided, the $2.5 trillion industry is finding that the easy money may be gone for good.

Private equity firms pool money from investors to take over companies, usually with a mix of cash and debt, intending to sell them later for a profit. Buyout activity reached a peak in 2005, 2006, and 2007, when firms completed deals valued at $1.6 trillion.

Many of those deals have disappointed investors, and more than $400 billion that private equity firms raised during the period has not yet been put to work. Pensions, endowments, and mutual funds have cut new commitments to buyout funds by more than half. Overall, private equity funds raised $281 billion last year, 57 percent below the record $646 billion collected in 2007, according to London-based researcher Preqin.

"From 2005 to 2008, firms pumped out profits in 24 hours, buying on Monday and selling on Tuesday," says Antoine Dréan, chairman of Triago in Paris, which helps firms raise money. "That made for fund-raising that was like a lottery in which every ticket was a winner. That was too good to be true." Owners now value at least 6 of the 10 biggest deals done during the boom at or below cost, according to public disclosures and communications with investors obtained by Bloomberg. Energy Future Holdings, the Dallas-based power producer formerly known as TXU, was the largest buyout in history when it was announced in 2007, with a value of $43.2 billion. At the end of the second quarter, Kohlberg Kravis Roberts (KKR) valued the company at 30 cents on the dollar.

Harrah's, the world's largest casino company, was taken private by Apollo Global Management and TPG Capital in a $30.7 billion deal completed in January 2008. Apollo valued the investment at 63 cents on the dollar as of June 30, according to an investor presentation. KKR bought electronic payments processor First Data in 2007 for $27.5 billion, including assumed debt. KKR is holding the investment at 60 cents on the dollar as of June 30.

Potential investors are reluctant to commit new money because private equity firms are sitting on an estimated $469 billion in existing capital commitments they haven't been able to invest, according to Preqin. Funds announced $128 billion in private equity deals over the past 12 months, less than a fifth of the $668.5 billion announced in 2007, according to data compiled by Bloomberg. At that pace, it would take more than seven years to invest the existing commitments, assuming funds borrow half the purchase price.

Deals that would allow funds to put money to work faster have fallen apart because investors are wary of overpaying. Blackstone, TPG, and Boston-based Thomas H. Lee Partners in May walked away from talks with Fidelity National Information Services (FIS), a payment services provider, over a $15 billion buyout after the company sought a higher price, say people briefed on the talks.

Blackstone, KKR, and Carlyle Group, the largest firms, have responded to today's tougher conditions in part by expanding beyond buyouts. Blackstone, created by Stephen A. Schwarzman and Peter G. Peterson in 1985, has cut its dependence on private equity to about 11 percent of its fee income. The largest unit at the firm by assets now is one that includes funds of hedge funds. KKR is seeking fees from underwriting debt and stock offerings by companies it owns and investing in oil and gas.

Still, stock market investors are wary. Blackstone's stock has declined to 10.43 in New York Stock Exchange (NYX) trading from an initial public offering price of $31 in 2007. Fortress Investment Group (FIG) has done worse, declining 81 percent since going public in February 2007. KKR, which has slipped 4 percent since listing its shares in New York on July 15, canceled a planned stock sale on Aug. 9. The firm cited "unfavorable market conditions."

Tony James ultimately wrung a $200 million commitment from the Oregon Investment Council for Blackstone's new fund. That was after the firm agreed to share more fee income, a deal it later had to extend to other investors. Blackstone had previously cut the annual management fee for the fund to 1 percent from 1.5 percent for investors with more than $1 billion in commitments.

James says the times when investors accepted fund terms without questioning are over. He recalls how, about a year ago, after the peak of the financial crisis, he and his partners sat down at the company's New York headquarters and agreed that each of them would start calling investors regularly to check in. "We as an industry were lazy," James says. "We were unresponsive to our investors. That world is gone."

The bottom line: Private equity firms are adjusting to life after the buyout boom, in which they are raising, spending, and earning less money.

    Before it's here, it's on the Bloomberg Terminal.