Private equity investors could see more cash back, better returns

Updated with correction

Private equity managers are more likely to sell than buy in 2015.

This should give investors more cash in their pockets from the expected distributions from these sales. These distributions of capital will help keep private equity's internal rates of return up.

But there is a hitch. Investors also will need to reinvest the money, which could be an issue in a world with fewer well-priced investments to be made, industry insiders say.

“Returns should be strong. It's more of a sellers' market than a buyers' market,” said Anthony J. de Nicola, co-president of New York private equity firm Welsh, Carson, Anderson & Stowe.

The firm distributed a record $5.5 billion in the past 18 months with $3.5 billion in distributions to investors in the past 12 months. And Mr. De Nicola expects to continue selling assets in 2015.

“The challenge will be for new capital to be deployed and generate returns for that new capital,” Mr. de Nicola said.

Everyone in the private equity industry will face the same challenge in the new year — finding attractive business opportunities, he said.

I think it (2015) will be a very interesting year,” said Alicia Cooney, co-founder and managing director of Boston-based Monument Group, an alternative investment placement agency. “The reason I say that is there is the potential for a whole series of tipping points.”

The U.S., for instance, appears to be in the later innings of a bull market, making the U.S. overdue for a possible major correction.

“That's a period of time when people can make a certain amount of money or lose a lot of money,” Ms. Cooney said.

Meanwhile, investors that want to keep their target allocations to private equity will have to increase the dollars they commit, said Andrea Kramer, managing director and head of Bala Cynwyd, Pa.-based Hamilton Lane Advisors LLC's global fund investment team. Hamilton Lane is an alternative investment consulting and money management firm.

These new distributions will “burn a hole in investors' pockets who will need to get the money back out,” Ms. Kramer said.

Overall, investors will be cautious and will be looking for value, Monument Group's Ms. Cooney said. But each class of asset owners has different considerations that will affect their private equity commitments in 2015.

Endowments are back at their target allocations for private equity, she said.

“We don't see them going beyond current allocations. As distributions continue, they will continue to invest and invest smartly,” Ms. Cooney said.

Corporate pension funds still will be under pressure to minimize contributions by generating returns. Corporate fund executives will look to equity and private equity to do that, she said.

However, public pension funds will be even more inclined to invest in private equity for the return generated, she said.

Not all private equity firms will have an easy time of capturing these new capital commitments. There will continue to be “manager haves and have-nots,” Ms. Kramer said. Those managers with superior performance will be the ones who will come back to the market and raise capital very quickly, Ms. Kramer said.

Those managers with just “OK performance” will have a tougher time raising capital, she said.

And it's not about brand-name firms any longer. Putting faith and capital in well-known managers simply on the basis of their credentials was a feature of the pre-financial crisis fundraising cycle. This time around, investors will be looking at managers' bottom lines and will be trying to determine whether the managers asking for their money will be able to re-create their great past returns going forward, Ms. Kramer said.

“Investing in established brand-name firms carries just as much risk as new names,” said Kevin Campbell, managing director and portfolio manager in the private markets group at fund-of-funds manager DuPont Capital Management, Wilmington, Del.

Limited partner due diligence will continue to be critical in 2015.

Blindly investing in brand is “a dangerous business,” Mr. Campbell said.

Investors have to do their homework before they make a commitment, he said. Questions include: What executives found the deal, added value to the company and saw the deal through to the exit? Which firm executives created the return and built the firm's brand? Are they still there, motivated and still a key part of the firm, or has a younger group taken over?

The increasing amount of distributions that are expected to flow back to investors in 2015 will do nothing to reduce the massive amount of uninvested capital commitments called “dry powder.” As of Sept. 30, there was a record high of $1.19 trillion of uninvested capital commitments at private equity firms' collective disposal, according to London-based alternative investment research firm Preqin.

Private equity general partners invest the money over a three- to five-year time frame, Ms. Kramer said.

“Can it be deployed in that time frame? My answer is 'yes,'” she said. “Think about the money in your pocket that you need to spend over a certain time frame. The concern is that you will spend it too quickly or spend it on things that are too expensive.”

This dry powder is also expected to have a dampening effect on new deals.

“The tremendous amount of dry powder, combined with morphing of investments and classes of investors, coupled with the fickleness of the stock market are challenges to getting deals done,” said Jason Freedman, partner in the private equity group based in the San Francisco office of law firm Ropes & Gray LLP.

The distinctions between hedge funds and private equity funds — as well as between family offices, foundations and sovereign wealth funds — are starting to disappear, Mr. Freedman said.

At the same time, there is a great deal of capital being raised for private equity and other alternatives including real estate, which is pushing up purchase prices, DuPont's Mr. Campbell said.

Some investors have told Mr. Campbell that they have already committed their 2014 private equity allocations and are dipping into 2015, he said. He wouldn't name the investors.

“When I hear comments like that I get nervous,” Mr. Campbell said. “In private equity, there is an inverse relationship between the amount of capital raised and returns.”

DuPont executives are still big believers in private equity, and real estate, for their return potential and diversification benefits, but in 2015 they plan to be careful and extremely cautious when investing in the asset classes.

Indeed, private equity managers turned to more creative investments in 2014 such as minority investments rather than control investments in companies and private investments in public equities, Mr. Freedman said. He expects this trend to continue into 2015.

These investments bridge the gap created when a company's valuation is too high for it to be an attractive buyout candidate, he said.

Instead of buying the company outright, private equity managers take a minority interest in the company by buying preferred stock or convertible preferred stock, which gives them income in the form of a set dividend rate with eventual redemption, Mr. Freedman said. These securities are also senior to common equities, which protect investors against their investment being wiped out.

Next year, DuPont plans to continue making just a handful of investments, focusing on small- to middle-market buyout funds that are less than $1 billion and venture capital funds with fund targets of less than $500 million, Mr. Campbell said.

“We won't go heavy into private equity. It's not a time to double down and do more investments than we would have,” he added.