Private equity megafunds are a washout for investors

Investors get burned by poor returns of 'club deal' portfolios

041612 rose
Talking: Jay Rose thinks managers have 'a lot of explaining to do' to investors.

Private equity deals that generated the most excitement before the recession are coming back to haunt their investors' portfolios.

Highflying buyout firms joined together in these “club deal” transactions between 2005 and 2008 to pick off companies up and down the Standard & Poor's 500 index. The plan was to take advantage of the growing economy and booming stock market to take public companies private, load them up with debt and sell them back to the market in a couple of years for tidy profits.

But because several private equity managers joined together to create these deals, institutional investors ended up exposed to a single company in a number of funds.

Now, that megafund exposure is giving investors a pain in their portfolios as some of these club deals are proving to be washouts.

The average return for the year ended June 30, 2011, for 2006 funds with more than $5 billion in capital — the megafunds — is about zero, according to Pitchbook Data Inc., a Seattle-based alternative investment research firm. Funds between $1 billion and $5 billion raised in 2006 returned 9% for the same period.

For many investors, megafirms were the way to go in the pre-crisis days: They were offered by name-brand private equity firms, and allowed larger institutional investors to commit the larger chunks of capital they needed to reach their private equity asset allocations.

For example, 70% of CalSTRS' $45.6 billion private equity program is invested in buyouts, with 61% of the program in buyout megafunds.

That “significant exposure to the relatively weak performance of the megabuyout segment ... has detracted from results during the latest five-year period despite stronger absolute returns over the recent year,” according to a report given last week to the investment committee of the $152.2 billion California State Teachers' Retirement System, West Sacramento.

The report from Mike Moy, managing director of private equity consultant Pension Consulting Alliance Inc., Portland, Ore., also noted that 76% of the overall portfolio's market value is from commitments made from 2005 to 2008.

“As a result, the investments from this four-year period are currently primary drivers of (CalSTRS' private equity) results,” the report noted. “All four of these vintage years are performing below median as of Sept. 30, 2011, with all four placing in the third quartile of the State Street PrivateEdge benchmark.”

Perhaps signaling its dissatisfaction with its megafund investments, sister fund CalPERS' current $1.5 billion sale of private equity interests on the secondary market is expected to include large holdings from name-brand buyout funds including Apollo Investment funds VI and VII, Carlyle Partners V, KKR Fund 2006, Providence Equity Partners VI and Silver Lake Partners III, sources said.

Officials of the $239.1 billion California Public Employees' Retirement System, Sacramento, declined to comment.

Debt weight

The biggest-ever private equity club deal, Energy Future Holdings Corp. — the Houston energy company formerly known as TXU — is teetering under the weight of its debt and plummeting oil prices. KKR & Co. LP, which participated in the $45 billion buyout with TPG Capital LP and Goldman Sachs Capital Partners, marked down its investment last year by more than 80%. The trio at the last moment extended the loans that made up close to 90% of the purchase price. Last year, the company reported a $1.9 billion net loss, which was down from a $2.8 billion net loss the year before, according to its year-end financial reports. Its first-quarter earnings will not be released until May 1, according a company news release.

Officials at KKR, TPG and Goldman Sachs declined to comment.

The result of investors' megafund experiences has them moving away from megabuyouts. And brand-name private equity firms are feeling the pain.

“Megafunds will need to downsize or prepare themselves for a much longer fundraising cycle,” said Jay Rose, partner at La Jolla, Calif.-based private equity consulting firm StepStone.

“They have lots of explaining to do; paying top dollar for large take-privates in the 2005 to 2007 time period is not what LPs had in mind when they committed capital to these buyout managers.  Additionally, many LPs are still upset with the significant uptick in consortia deal activity, as they ended up with exposure to the same company from four or five managers.”

Luba Nikulina is senior investment consultant and global head of private markets in the London office of investment consultant Towers Watson & Co. She said “quite a few (megafunds) have significant issues with deals in 2007 and 2008.”

While a number of private equity firms “were able to do things with (portfolio) companies ... initially companies were overleveraged and the question is whether investors will get returns for taking so much risk, locking capital in for so long and paying significant fees,” Ms. Nikulina said. “It seems unrealistic to achieve. The overall rate of return for 2006 to 2008 funds is likely to be very disappointing.”

Public to private

One of the megafunds' biggest problems, according to industry watchers, is the type of deals they transacted.

“The $5 billion-plus funds, in the peak, were doing the big public-to-private deals,” said John Gabbert, CEO of Pitchbook Data. “And ... if a company is private, there is going to be a discount due to liquidity issues. But, there isn't a liquidity discount for publicly traded companies. My theory is, take the discount out and you are paying a premium to the stock market. So at the height of the height, they might have paid a premium.”

StepStone's Mr. Rose said that even though terms on the debt at the peak were very favorable for the general partners, “the sheer magnitude of debt was clearly not sustainable.”

“Many of those club deals are now wipeouts and have been a windfall for the distressed debt managers over the most recent cycle,” he added.

In anticipation of more disappointing returns, many large institutional investors are trimming the number of their private equity relationships, in part to help reduce their exposure to a single deal, Ms. Nikulina said.

“The smaller number the relationships, the smaller the likelihood of this occurring,” she said.

Their experiences are adding to investors' desire to reassess their relationship with private equity. Historically, they traded private equity's illiquidity for returns that were supposed to be “both superior to, and uncorrelated with, the returns available in the public equity markets,” said Alan Jones, managing director and head of Morgan Stanley (MS) Global Private Equity, New York.

”Over time, investors in private equity funds have grown concerned about funds whose returns merely mimicked those of a leveraged investment in the public equity markets,” said Mr. Jones, who invests in the middle market.

“These "closet beta' funds provided neither the superior returns — the alpha — that private equity firms had historically created through active management of their portfolio companies, nor the diversification relative to the public markets that operationally focused ownership can also create.”

Smaller sights

Investors expected to see more unique portfolios. They are moving away from mega buyouts in favor of small and middle-market buyouts and sector-focused funds, StepStone's Mr. Rose said.

Still, not all megafunds are losers, noted Gitanjali Swamy, CEO of Lexington, Mass-based AARM Corp., a research firm. “Not everyone is bad. There are lots of great megafunds,” Ms. Swamy said. “The truth is, megafunds, per se, are not necessarily a bad thing.”

Even if they could collect enough capital from investors, the economic environment is not conducive to megadeals, said Ted Koenig, CEO of Monroe Capital LLC in Chicago.

“Megadeals aren't happening,” Mr. Koenig said. “There's not as much capital available for megadeals, bank debt is not as readily available and the leverage is not available. Funds have to put up 40% in equity in deals and so they are focused on the middle market, which requires less absolute dollars and where the high-yield market is very strong.”