The burgeoning popularity of private equity investing, which has become the alternative investment of choice for large pension plans, could drive down returns in 1997.
With the U.S. private equity market - buy-outs, restructurings and other deals - looking almost as toppy as the public market, many institutional investors are looking to international private equity fund investments for 1997.
Fund raising was brisk in 1996, with $18.2 billion raised for leveraged buy-out and corporate finance-type funds, nearly reaching 1995's total of $19.1 billion, according to the Private Equity Analyst, a newsletter in Wellesley, Mass. Figures don't include real estate funds. Venture capital was nearly even, at $4.3 billion, vs. $4.5 billion in 1995.
Kopin Tan, managing editor of Buyouts, a newsletter in New York, said funds become oversubscribed very quickly and some have to turn investors away. Cases in point: Kohlberg Kravis Roberts & Co. intended to raise $2 billion for its buy-out fund but ended up with $4.6 billion; Donaldson Lufkin & Jenrette sought to raise $2 billion but attracted more than $3 billion in less than six months.
Philip Pool, managing director of DLJ, said his firm raised well over $7 billion in assets this year, including its own $3 billion merchant banking fund. "This is an all-time indoor record for any agent," said Mr. Pool, who joined DLJ in 1994 from Merrill Lynch & Co.
He said the industry is maturing. "More investors have made formal commitments to the asset class and institutional investors have to reinvest the money they get back."
What's more, pension funds have confidence in the firms raising money. "A much more established group of general partners is out there who have proven track records."
Kevin Albert,managing director-investment banking of Merrill Lynch & Co., New York said 1997 will be a big year for international private equity funds. His firm is raising capital for three Latin American funds, one Asian fund, two European funds and one Russian fund in 1996. Two years ago, the firm only raised one international fund.
In '96, "35% were international. That's the big growth area. Most plans have a pretty big complement of U.S. funds. Most are just starting to chow down on international," Mr. Albert said.
Warburg Pincus & Co., New York, using Merrill as its agent, is seeking to raise $500 million in its first international fund, Warburg Pincus International Ventures, which will do venture capital, private equity and restructurings, mainly in Europe. The fund will invest in deals, in a pre-determined ratio, alongside the firm's $2 billion domestic fund raised in 1996.
Hancock Venture Partners, Boston, raised $1 billion for its Hancock International Private Equity fund in 1996. Salomon Brothers Inc. raised an $800 million international fund called CWB Capital Partners. And Albion Alliance raised a $500 million South American fund called Mercosur Equity Fund L.P.
Merrill alone raised more than $3 billion for funds in 1996, a bit below the level of the past two years.
"This high level of commitments introduces new uncertainties to the private equity market. The U.S. private equity market recently has been deluged with investor capital, effectively there are more players with more capital chasing a fixed number of deals. Accordingly, prices are often bid up and potential returns are lowered," wrote James R. Hedges IV, managing director of LJH Global Investments L.L.C., a Darien, Conn., hedge fund consultant, in a white paper on global private equity investments.
"As the U.S. becomes saturated with capital, investors seeking superior absolute rates of return and the diversification benefits of private equity must look to international and emerging markets."
While endowments, foundations and corporate pension funds have been longtime players in alternative investments, some public funds - such as the New York State Teachers Retirement System, Albany - are just entering the fray. Foreign pension funds, such as the Netherlands' Stichting Pensioenfonds ABP, also are interested in U.S. alternative investments.
Long-time investors are flush with cash distributions from prior funds that need to be redeployed. That might, in part, explain Oregon Public Employes' Retirement System's $800 million commitment to KKR, whose prior funds have performed very well for the $23.3 billion retirement system, Salem.
The pipeline of new private equity offerings for 1997 is rumored to include funds from Castle Harlan; Texas Pacific Group; Joseph, Littlejohn & Levy; Charterhouse Development Capital Ltd.; and Forstmann Little & Co., which hasn't raised a fund in about two years.
Lehman Brothers may raise a $1.5 billion merchant banking and buy-out fund, Mr. Tan said.
"The biggest risk (for 1997), and it probably is a pretty big risk, is that a lot of money committed will not get invested," Merrill's Mr. Albert said.
That doesn't seem to worry Craig Whiting, general partner of WPG Private Equity Partners V, the fifth private equity fund of Weiss, Peck & Greer, New York.
The firm did no deals from the beginning of 1989 to the end of 1990 when "the market was peaking," he said.
WPG likes its funds to be midsized. "We don't want to do larger funds than $200 million because we don't want to feel pressured to do bigger deals or more deals," Mr. Whiting said. He said the market for deals he seeks, in the $35 million to $100 million range, "is not quite (as) intimidating" as the market for big deals.
General partners point out that despite the heady flow of capital chasing deals, the private equity market is not nearly as speculative as it was in the late 1980s because leveraged buy-out funds today typically put far more equity, 20% to 30%, into deals. And terms are much more favorable to limited partners, so the general partner doesn't make money until - at the very least - investors have earned back the amount of the fund's management fee. Also, banks are more prudent about their lending criteria.
Saunders Karp & Megrue, a buy-out firm in New York, is about to close its second fund, SKM Equity Fund II, with more than $500 million. Investors in its first $300 million fund include the pension funds of AT&T Corp. and NYNEX Corp.
General partner John Megrue is concerned about 1997.
"Frankly there are a lot of troubling signs out there," he said, citing figures showing nearly six-fold growth in buy-out fund-raising volume since 1991.
"That's just wild. Those are just huge numbers," Mr. Megrue said.
Deal prices are up, with multiples at levels close to their 1988 to 1989 peak. And with the higher equity component, "deals that don't work really hurt from a portfolio return standpoint. Even on good deals, you make three or five times your money, not 10 times" as in the highly leveraged deals of the 1980s, he said.
Messrs. Megrue and Whiting prefer direct deals to those offered to them by investment bankers in an auction-type scenario. "The chances of me getting to the finish line are zero if that many people are at the party," said Mr. Megrue, noting the auction process, where a deal is circulated among 100 to 150 investors, is one reason prices are going up.
Mezzanine funds are a more efficient way to put dollars to work, according to Dana Donovan, senior investment officer at John Hancock Financial Services, Boston. The funds, which represent a small percentage of pension assets committed to alternative investments, offer "the opportunity to deploy large pools of capital in a superior returning investment over a long time frame" of five to 10 years, said Mr. Donovan, whose unit runs more than $700 million of Hancock's own capital in mezzanine deals. "Buy-out or venture capital funds can't deploy as much capital for as long a period," he said.
What's more, he noted, the mezzanine market "doesn't fluctuate a lot with interest rate or stock market valuations." While the mezzanine market is getting "frothy," there are still some very attractive deals out there, he said. "It doesn't have the risk a venture or buy-out fund has, and it doesn't have the returns."
Still, Hancock's mezzanine investments have earned a hefty compound annual rate of return in the low 20% range over the past 10 years. In 1997, Hancock might raise a mezzanine fund for outside pension fund investors.
"This is a logical market for us to get into because there aren't any real big dominant players in mezzanine investing," Mr. Donovan said.
In venture capital, fund raising has leveled off during the past few years with pension funds making commitments to established venture capital firms, rather than funds run by technology entrepreneurs known in the industry as "angels," said Steve Schaepe, general partner of Weiss Peck & Greer Venture Partners, which runs $400 million.
Venture capital returns have been buoyed by the strength of the initial public offering market, affording investors a swift exit strategy, and fundamental changes in technology, such as deregulation of the telecommunications industry and the emergence of the Internet, that have led to start-ups, he said.
"Later-stage deals are a little pricey, but in early stages there are cheaper buys," Mr. Schaepe said.
In addition to general private equity funds, Merrill Lynch also is raising a number of real estate-related funds. It is raising a $500 million opportunity fund for JER Real Estate Partners, McLean, Va., run by J.E. Robert Cos. The fund will do deals ranging from buying buildings to purchasing tax liens.
A unit of Jardine Fleming Group, Hong Kong, will begin raising $200 million for an Asian real estate fund in January, also using Merrill. This is Jardine Fleming's second such fund.
The Starwood Opportunity Fund IV L.P., which closed in December, raised $850 million for private equity and mezzanine debt investments in real estate, according to Terry Clark, a director of Merrill, the placement agent.
Merrill also is raising Landmark Equity Fund VI, a fund that plans to purchase commingled real estate fund interests of the State of Connecticut Trust Funds.
