Rising prices dampen PE return targets
By: ARLEEN JAOBIUS
Pensions & Investments
August 1, 2011

Private equity returns are starting to come back, but investors shouldn't expect to reap the 20% per year they once took for granted.  A potent combination of cheap debt and a $375 billion capital overhang from older funds is causing purchase prices to rise faster than the sluggish economy, and that will hurt returns.

“We believe that there will be an ever widening dispersion of returns between first-quartile and fourth-quartile funds,“ agreed David I. Fann, president and CEO of PCG Asset Management LLC, a La Jolla, Calif.-based private equity consulting and investment management firm. What will separate the winners who can create value and those that can't are unique deal flow, executing operating improvements, uncanny vision to see value where others can't and pure luck, he said.

In the fourth quarter of 2010, private equity posted 7.65%, the highest quarterly return since the second quarter of 2007, and up from 6.57% from the third quarter, according to the most recent State Street Private Equity index returns. Many observers have pointed to the high returns enjoyed by funds raised after economic downturns as signs of renewal.

But, industry insiders are predicting that, this time around, there will be a big difference between firms that can add value and firms that can't. “The question is, "What's the accretion rate of value going forward? What type of growth will they have going forward?,'” said Stephen H. Can, managing director and global head of strategic partners at Credit Suisse, New York. “Private equity will accrete value but not the 20% a year. Most companies will have trouble getting anywhere near the 15% to 20% range.” He added that there will be a big difference between private equity firms' performance.

"Spectacular failures"

Several hundred funds have closed or are not now raising new funds, said Marshall Sonenshine, chairman and managing partner of New York investment bank Sonenshine Partners LLC. Too much money chasing too few deals has caused funds to bid up prices and bid down returns, he said. “There have been some spectacular failures and many disappointments in the credit crisis period,” he said. The higher prices private equity firms are paying will make it more difficult for these firms to make the returns their investors expect and to raise their next fund, Mr. Can said.

“The question for general partners and primary investors is that sellers (of companies) are getting pretty full value. They are not selling cheap,” Mr. Can said. One reason for the high prices is the overhang, he said. U.S. private equity funds as of Dec. 3 had a combined $375 billion in assets, net of fees, left to invest from the $915 billion those funds raised from 2005 to 2010, according to research released last month by Cambridge Associates LLC.

The clock is ticking on that mountain of unspent capital, putting pressure on private equity firms to invest the money before the investment periods and/or extensions expire. “Private equity managers have a lot of money they have to put to work, and that has to impact the quality of the deals,” said Jeffrey MacLean, CEO of Seattle-based consulting firm Wurts & Associates. “We look at the overhang as one indication of what kind of valuations we are likely to get from private equity.”

All things being equal, Wurts executives prefer asset classes that are cash starved because that's where investors can get return from beta, rather than relying on alpha, he said. Wurts executives “focus more on mezzanine and distressed debt as better ways to play the private markets,” he said. “We want to invest when there is no money on the sidelines waiting to get into it,” Mr. MacLean said. “That's not the case in private equity. On a risk-adjusted basis, private equity probably isn't as attractive as it once was.”

Another reason for the skyrocketing sales prices is inexpensive leverage. “Leverage is almost free,” Mr. Can said. Low interest rates mean that a buyer can pay more for companies, he said.  But industry insiders say there are other reasons private equity managers are paying higher prices.

More factors

“Overhang and cheaper debt are only two of the factors driving higher prices and possibly, lower returns,” PCG's Mr. Fann said. “Other reasons include improving public equity valuations (market comparables), increased competition from corporate buyers, improving outlook for revenue, EBITDA and earnings growth and the re-emergence of the substitutes to a sale such as recapitalizations” and initial public offerings.

What's more, private equity shares a number of characteristics with public markets, which are only expected to produce rates of return in the mid- to low-level single digits, Mr. MacLean said. “Private equity is not going to do well if public equity is not going to do well,” he said.

PCG Asset Management's also compares private equity with the public markets. Typically, PCG execs compare it to a public equity index such as the Russell 3000 index plus a risk proxy of around 300 basis points to 400 basis points, Mr. Fann said. “In this environment, we believe most private equity firms are underwriting to high teens/low 20s investment rate of return for equity,” he said. “Factoring in fees (and) modest losses to offset portfolio gains, this should generate a low teens net internal rate of return.”

Contact Arleen Jacobius at ajacobius@pionline.com