69% of private equity firms' assets in unsold companies

Private equity firms are sitting on the largest collection of unsold portfolio companies in the history of the asset class, and investors are taking notice.

The glut is enormous: an estimated 6,500 unsold portfolio companies as of year end, representing 69% of private equity firms' total assets under management as of Sept. 30. That is the highest number of unsold portfolio companies ever recorded by PitchBook Data Inc., a private equity and venture capital research firm in Seattle that has been tracking data since 2004.

Institutional investors are beginning to ask managers about these portfolio companies and the likelihood of achieving exits — before committing capital to new funds. Whether these holdings are sold for sizable profits could affect private equity returns in years to come.

For example, both the $41 billion Los Angeles County Employees' Retirement Association, Pasadena, and the $38 billion Teachers' Retirement System of the State of Illinois, Springfield, tracked Silver Lake Partners' portfolio company exits before making commitments to its latest fund, Silver Lake Partners IV. Each eventually committed $150 million.

LACERA's staff named exits of unsold portfolio companies as one of its two “investment concerns” related to investing in Silver Lake's fourth fund, according to a staff memo for the Feb. 13 board of investments meeting. The staff noted Silver Lake has about $7.6 billion invested in 24 still active companies. Some 70% of the capital invested in Silver Lake's second fund, which closed in 2004, and 75% of the capital invested in Silver Lake's third fund, which closed in 2007 is still active.

And it's not just Silver Lake. LACERA staff noted in the memo that a “lingering impact of the financial crisis is the large quantity of unsold portfolio companies building up in large buyout funds.”

Andrew R. Cristinzio, McLean, Va.-based partner in PricewaterhouseCoopers LLP's deals practice, estimated the overhang in assets is double 2006 levels.

“If you look at private-equity-backed portfolio companies back at pre-crisis levels, current private-equity-backed portfolio company overhang at the end of 2012 was somewhere around 6,500, which is estimated to be double that of the pre-2006 period,” said Mr. Cristinzio, citing PitchBook data.

Indeed, of the more than $3.27 trillion in total worldwide private equity assets under management as of Sept. 30, $2.27 trillion is “unrealized portfolio value” or unsold portfolio companies, according to data prepared for Pensions & Investments by Preqin, a London-based alternative investment research firm.

The worst offender in terms of vintage year is 2007 funds, which as a group have the highest unrealized value of portfolio companies — $527 billion — compared with total assets under management of $617 billion, the Preqin data show.

When Preqin compared the proportion of private equity companies invested in each year since 2006 that are still being held by fund managers, 70% of companies invested in throughout 2006 are still being held, said Nicholas Jelfs, Preqin senior analyst and press officer.

The overhang in unsold private equity portfolio companies has never been higher in the history of the asset class, asserted Michael G. Fisch, president and CEO of American Securities LLC, a private equity firm in New York.

“The overhang that is not sufficiently talked about is not the overhang of capital, but the overhang of older portfolio companies and older funds that have not been sold and need to be sold,” Mr. Fisch said.

What ends up happening to this glut of unsold portfolio companies could have a big impact on the private equity industry.

Some firms can't sell some of their portfolio companies because they are worth less than their original investment, Mr. Fisch said.

“What will happen to them? Who will buy them? When will they get sold? What will happen to the returns of the industry when they do get sold?” Mr. Fisch asked.

Every situation will be different, he said. If a manager's relationship with the firm's limited partners is good, investors will give the general partners more time to sell their portfolio companies.

Where the general partner-limited partner relationship is not good, the entire private equity fund might be sold to another general partner, or investors might bring in a new general partner because they have lost faith in the original one, Mr. Fisch said.

Holding onto portfolio companies also can affect investors' ability to make new commitments, said Sanjay R. Mansukhani, senior manager research consultant in the New York office of Towers Watson Investment Services Inc. That's because exiting companies is a prime source of distributions back to limited partners. “When net asset value is not coming back in distributions, investors find themselves overallocated” to private equity, Mr. Mansukhani said.

Given the lessons of the financial crisis, when overexposure to alternative investments made the entire portfolio less liquid, investors are loath to increase their target allocation in order to commit capital to additional private equity funds, he explained.

Portfolio company refinancing, called recapitalizations, has led to some distributions to limited partners, but most distributions in Towers Watson's portfolio are from portfolio company exits, Mr. Mansukhani said.

This makes it tougher for general partners to raise money, even when their portfolio valuations are rising from the effect of the uptick in the equity markets in the U.S. and the value general partners have added to the portfolio companies, Mr. Mansukhani said.

“Even core investors are giving less money, even for great-performing funds,” he said.

Distributions also are a sign that a private equity firm is a solid performer, noted David Fann, president and CEO of TorreyCove Capital Partners LLC, a San Diego private equity consulting firm.

“Most private equity investors would like to see at least a portion of the prior fund's investments achieve realizations before committing to a new fund,” Mr. Fann said. “Realized investments validate performance and success.”

Another aspect of this historic overhang of portfolio companies is the damage it is expected to do to overall private equity returns.

“It's just on the math of the internal rate of returns,” Mr. Mansukhani said.

A longer portfolio company holding period will affect internal rate of return because IRR is time based.

“General partners may gain a little multiple by holding out for a better price, but what it is going to do is dilute the internal rate of return,” he said. “You have to balance those two things.”

It also becomes an issue of capacity, whether a manager with a collection of portfolio companies in older funds and a new fund has enough executives to manage the entire portfolio, Mr. Mansukhani said.

“It's about bandwidth,” Mr. Fann said. “Understanding the capacity of general partners to make new investments is critical. Investors want their GPs to work solely on their behalf. Investors don't want to commit to funds whose general partners are consumed working on the previous fund's investments.”

However, some industry executives are betting the portfolio company overhang might diminish if the economy, at least in the U.S., continues to improve and debt for deals remains available.

“Clearly, there's a general acknowledgement that there's been an increase in the average hold time from investments made in the 2007-2008 time frame,” said PricewaterhouseCoopers' Mr. Cristinzio. “But if the economy continues on the current trend and financing continues being available as it is, we will see an increase in exits.”