Private equity hurting from the boom

No matter what they say, private equity managers will struggle to deliver stellar returns from the vintages of the global recession. Simon Mumme speaks to Jane Welsh, global head of private markets research at Towers Watson, about why the glut of capital committed to private equity in its heyday could depress future returns.

It’s tough going for private equity managers still pitching for investor capital.

At $52.4 billion, the amount of money raised by private equity managers in the first quarter of 2010 is only $2.4 billion more than the sum raised in the final three months of 2009, finds Preqin, a research firm.

But while fundraising and managing existing investments are the immediate hardships faced by private equity firms, the greater challenge will be providing the big returns expected from recession-era vintages.

Much of the capital raised in the private equity heyday of 2007 still awaits investment, and Jane Welsh, global head of private markets research at Towers Watson, says these commitments are estimated to level out anywhere between $400 billion and $1 trillion. Whatever the amount, it far outweighs the sum of invested money, resulting in a “capital overhang”.

She says this “unprecedented” volume of commitments undermines the private equity industry’s overture to investors in the aftermath of the credit crunch: that the vintages of recession years have historically generated the highest returns.

“Normally, a lot of private equity guys present charts showing that investments made just after recessions have spectacular returns. But this time will be different, partly because of the capital overhang – because as people put it to work it will push up the prices of assets they buy.”

The venture capital industry faced the problem of having too much money after the dotcom crash. Managers were loaded with capital in the late 1990s as the internet unleashed opportunities for new and innovative start-ups, but struggled to meet investors’ expectations as the volume of commitments swamped the opportunities on offer.

“They got burnt by the tech wreck,” Welsh says.

In the next few years, managers will also have to overcome the wall of refinancing due from 2013 onwards. It’s improbable that banks will again grace private equity firms with the light covenants agreed upon in 2007. It has been difficult for managers to even get banks to talk about this subject, Welsh says.

But the refinancing problems should extend to the broader business world, and provide opportunities for distressed debt and turnaround managers.

“The banks haven’t wanted to take the write-offs. They’ve been helping businesses limp along, and we haven’t seen the flow of opportunities – but there is a wall of refinancing to be done.”

“In theory, the distressed [debt] investors could really pick up a lot of fantastic stuff at that point.”

But investors should carefully select which firms they invest in, given the broad dispersion of returns between upper quartile managers and the rest. In addition to distressed debt managers, investors should look for mid- to large-sized buyout funds with “real operational expertise” and few problems in their legacy funds, Welsh says.

They should also look carefully at what is happening among private equity secondaries funds.

“One area that looks potentially like a bubble is the secondaries market. A lot of money has been raised by specialist secondaries funds, but they haven’t put it to work,” Welsh says.

This is largely because vendors were unwilling to accept the deeply discounted prices offered by would-be acquirers. Now, the case for discounts has expired and “a lot of money is chasing deals”.

Specialist secondaries managers also face competition from primary fund-of-funds who are selectively buying secondary interests in individual.

Catch and keep

Private equity’s return to earth has also provided investors with an opening to demand- and receive – lower fees from managers.

“We’re seeing some movement on fees, getting management fees down to reflect the cost of running the business rather than a source of profit,” Welsh says.

“Some US funds are moving towards the European approach, where the manager doesn’t get any carry until the client has got their capital as well as their preferred return.”

This ‘preferred return’ is the amount of performance an investor is entitled to under the management contract. If a manager delivers a 10 per cent return, and the investor’s preferred return is 8 per cent, they receive that amount while the manager keeps the remaining 2 per cent. This residual capital kept by the manager is called the ‘catch-up’ fee.

This is not so noticeable if the manager generates a big return, such as 50 per cent, but in a low-return environment, the catch-up fee becomes a point of concern.