Reduced returns in store for European private equity funds

U.S. investors might need to downsize their return expectations as they sift through an estimated €40 billion ($49.7 billion) in new European private equity funds expected to be raised by year-end 2005.

An anticipated oversupply of capital — only about $25 billion was raised by European private equity funds in 2003 — means investors should not expect the new crop of funds to produce the same high returns as European funds have earned in the past, industry insiders say.

That would be a problem for pension fund investors counting on the expected excess returns that private equity and other alternatives have brought to their portfolios.

The private equity net return for the five years ended Dec. 31, 2003, was an annualized 10.2%, according to the London-based British Venture Capital Association's performance measurement survey. And while observers expect returns to drop, no one was willing to give an estimate.

"There's no question there is going to be a huge fund-raising boom beginning now and carrying through a good part of next year," said Erik Hirsch, chief investment officer for Hamilton Lane Advisors, Bala Cynwyd, Pa. "The European market had performed well and had good returns, but we are heading into a different market …. Good returns will be harder to come by." Hamilton Lane has $32.5 billion in private equity commitments, of which $3 billion is for European funds.

U.S. institutional investors are keeping their eyes on Europe's fund-raising climate because many have invested significant percentages of their portfolios in European private equity. More than 50% of the assets in European private equity funds have been committed by U.S. investors, and that is not expected to change.

"U.S. investors have an incredibly meaningful portion of most European private equity funds," Mr. Hirsch said. Much of the action in Europe is around large buyout funds; the middle- and small-market private equity markets are too new to talk about big trends, he noted.

Officials at $3.6 billion San Bernardino County (Calif.) Employees' Retirement Association, which in June made its first allocation to European private equity, are watching for the European fund-raising to begin. "We anticipate good groups to come to market and we're assuming that when our advisers are saying ‘good groups' that the returns will be there," said Don Pierce, investment officer.

He added that San Bernardino has invested in the asset class through two fund managers, Partners Group Inc. and Standard Life Investments, which manage $220 million each with full discretion — Standard Life with a fund of funds and Partners Group with a separate account.

Some of the firms that have started or are expected to begin fund raising for European market funds with at least €2 billion ($3.7 billion) each are 3i Group, Kohlberg Kravis Roberts & Co., Bridgepoint Capital, BC Partners Ltd., CVC Capital Partners and Apax Partners & Co. In all, Hamilton Lane executives expect 10 private equity firms to raise megabuyout funds for the European market beginning in the fourth quarter.

Private equity money managers have a finite period of time — about five years per fund — to make investments, said Norman J. Leben, executive vice president and managing director of private equity services at New York-based BISYS Private Equity Services, which provides advisory and administrative services for the private equity industry. The pressure to invest a stockpile of cash might force some managers to pay more for deals than they would have in a less competitive market, he said.

"We've seen pricing pressure over the last six to 12 months," said Tim Green, senior partner at GMT Communications Partners, a London-based private equity firm with €500 million under management that has focused most of its investments in middle-market European companies. These high prices paid for portfolio companies negatively affect fund returns, Mr. Green said.

"There is a lot of money looking for homes. Too much money, too few deals," Mr. Green said. "We are sensing an acceptance of target returns that are lower." Still, these reduced private equity returns are higher than those expected from the traditional stocks and bonds asset classes, he said.

U.S. consultants are projecting 12.2% private equity annual returns for the next year, compared with single-digit returns for bonds and public stocks.