Outlook 2005: Private equity

The big question in 2005 for private equity is, will it generate satisfactory returns or will high prices force down returns, causing more investors to lower their allocations to the asset class?

Other questions expected to arise are:

• In venture capital, how far will the disclosure push go?

• Will the use of cheap debt continue to be a vehicle to recapitalize portfolio companies?

• Will investors continue to be able to reinvest their profits in the asset class?

• Will the lines between private equity and hedge funds become even more blurred as hedge funds take business from mezzanine funds?

• Will investment teams from more sophisticated pension funds set up separate investment management groups, using the Harvard Management Corp. as a model to manage other investor dollars?

• Will the rapid growth in India and China translate into attractive returns for private equity groups operating there?

Many investors also are questioning how they position the asset class within their portfolios.

"I think among the issues is the whole set of questions about what is really happening to the asset class," said Josh Lerner, the Jacob H. Schiff Professor of Investment Banking at Harvard Business School, Boston.

The positive returns generated by private equity could be its downfall, as more institutional money flows into the asset class and investors and their advisers start to question whether continuing returns can be sustained.

"There continues to be more and more capital coming into the private equity arena," said David Larsen, partner in the trust service practice of KPMG LLP, New York. "If that is indeed true, where is that capital going? Conventional wisdom is that you only make returns you need to in private equity in the top quartile funds. That means three-quarters of the money is underproductive. How do you account for that?"

A number of sophisticated investors like the Yale University endowment already have reduced their allocations to private equity, Mr. Lerner said. Between 2001 and 2003, the most recent data available, private equity dropped to 14.9% from 18.2% of total assets at the $11 billion endowment. At Harvard Management Corp., Boston, which oversees the $22.6 billion Harvard University endowment, private equity investment dropped by a percentage point to 7.7% as of June 30.

At the same time, other institutional investors are clamoring to get into private equity, Mr. Lerner said.

"Are the new guys right or are the other, seasoned investors correct?" he queried.

In general, the most sophisticated investors are rethinking their private equity investments in favor of other alternative investments like timber, cropland and natural resources, Mr. Lerner said. For example, between 2001 and 2003, Yale's investment in real assets rose to 20.9% from 16.8%. The information came from an updated case study of the Yale University program conducted by Mr. Lerner and Jay Light of the Harvard Business School.

The endowment eased back on private equity because there is a lot of money chasing the same deals, which hinders returns, he said. Still, brand-name private equity and venture capital firms had no trouble raising funds in 2004, a trend expected to continue in 2005.

For firms that have public funds as limited partners, the push to disclose private equity returns could reshape the investor landscape. And smaller venture capital fund sizes are putting fund managers from top-performing funds in the driver's seat as far as who they select as their limited partners and the terms and conditions, said KPMG's Mr. Larsen.

Substantial pressure for governance reform from limited partners also might emerge, said Mr. Lerner.

The disclosure dispute might cause more private equity managers to look to hedge funds to finance private equity deals instead of going to big pension funds like $182.3 billion California Public Employees' Retirement System, Sacramento, or the $80 billion Teachers Retirement System of Texas, Austin, said Mario Giannini, chief executive officer of Hamilton Lane Advisors, Bala Cynwyd, Pa.

"That could change the dynamics" because hedge funds are not subject to private equity disclosure, Mr. Giannini said. "That is something we would look at carefully. We're not doing it now, but a number of general partners are having that discussion."

One way to return money to limited partners that became popular in 2004 and is expected to continue is using cheap debt to recapitalize portfolio companies. Even interest rates rising moderately should not slow capitalizations.

"Limited partners are delighted because they still own part of the company, just highly leveraged," said William Simpson, partner and chair of the private equity practice of Paul, Hastings, Janofsky & Walker LLP, Los Angeles-based law firm. "Some fund managers are now considering doing it a second time."

This trend has accelerated the private equity cycle because fund managers were realizing returns on their investments sometimes within 12 to 18 months of buying the companies, said Mr. Simpson. The changes in the dividend tax rate means the general partners are not hit with a huge tax bill for leveraging the portfolio companies and paying a big dividend on them, he explained.

"It's a good way to goose up the IRRs (internal rates of return)," Mr. Simpson said.

However, the money returned to investors creates another problem: in a high-priced environment, will investors be able to reinvest the money in private equity?

"Fund-raising trends are back up and fund raising is going up in 2005," KPMG's Mr. Larsen said. "Intuitively, I believe venture capital (fund raising) will be down and buyouts will continue to grow," he said.

Even with a number of buyout funds in the range of $3 billion to $5 billion, general partners are complaining they don't have enough money to do the deals that are out there, Mr. Larsen said.

"That's (buyout) the place where a lot of money can go to work. The next question is, with that size of funds, can you get returns you have historically been looking for?" he said.

On the venture side, most of the highly sought after venture capital funds already raised money in 2004, said Parag Saxena, managing partner with INVESCO Private Capital, New York.

"These funds get a disproportionate amount of money," he said.

Unlike buyout funds, the average venture capital deal price is expected to drop, Mr. Saxena said. Venture capital funds are 25% to 35% smaller with some brand-name funds like Sequoia Capital being 20 to 30 times oversubscribed.

"That creates an imbalance and so there is not a lot of (second and third) rounds of financing, which is reflected in pricing, and that will continue," Mr. Saxena said.

Mr. Larsen said he expects more pension funds to reduce their target allocations to private equity. However, they will be making the change in response to the increased asset size of their entire portfolios caused by the recovering stock market. "Conceptually, it's a mathematical problem," Mr. Larsen said. "It's more mathematics than belief in the sector."

In the hedge fund arena, firms are increasingly encroaching on mezzanine investing, said William McCormack, partner and co-chair of the private equity group of Ropes & Gray, a New York law firm.

"The hedge funds are getting more and more into mezzanine," Mr. McCormack said. The difference between private equity and hedge funds is getting more and more blurred, he added.

Another trend expected this year is the outgrowth of private equity teams from the most sophisticated pension funds and endowments into separate management companies. This model, loosely follows the Harvard model, where a separate entity manages the university endowment and pension funds, Mr. Larsen said.

The teams will continue to manage the money for the sponsor but it will be a self-contained unit separate from the sponsor, he said. Part of the attraction is getting out of the bureaucracy of the large institutions.

Looking overseas, some observers say the buyout markets and Asia are going to take off in the next 18 months.

"What I find is European and Asian investors have spent a lot of their allocated dollars," said Mr. McCormack. "American investors are behind and have so much more money to invest."

This means more U.S. investors could begin to invest in Europe and Asia this year.

After disappointing investments with private equity managers investing in China in the early 1990s, some institutional investors are either making smaller commitments or doing more research, said Raymond F. Henze, group managing director of international private equity and real estate for TCW, Los Angeles.

‘There's been a sea change. Funds are making money through buyout and growth (private) equity and it's bringing people who were on the sidelines," Mr. Henze said.

Brand-name buyout firms like CVC Capital Partners, Carlyle Group and JPMorgan Investment Management, are preparing to raise China funds, Mr. Henze said.

"There's a number of funds with Asia, China, India or Russia — a number of country-specific funds — coming together," KPMG's Mr. Larsen said.

However, whether these funds make money will depend on if they can make exits by either selling the company or taking it public, which may be more difficult in a less developed economy like China's.

"The big question in most markets is how do you exit," Mr. Larsen said. "If you don't have a fully functioning stock market, there won't be IPOs and then you have to recapitalizations or sales as exit options. … If you have a good exit strategy, then it works."