Website design By BotEap.comInvesting in Private Equity (PE) has grown dramatically in the last 5 years, and private equity funds have produced excellent returns for investors. Private equity funds have become a very popular and fashionable “alternative investment” in which many large investors (high net worth families and institutional investors) have felt they had to get involved. Private Equity funds attempt to acquire companies or businesses at a low price. They use a lot of tax-deductible debt to capitalize on their returns, cut costs to try to improve short- and long-term profitability, and sell assets to raise capital. Sometimes they pay themselves a dividend from assets owned by the company and eventually (2-5 years later) sell to another buyer or take the company public at a higher valuation.

Website design By BotEap.comThe favorable conditions that helped fuel the recent private equity boom have changed dramatically over the past year. Future returns from private equity will be much lower than they have been in the last 5 years and could prove quite disappointing for many investors. I think the private equity peak was in 2006 and the first half of 2007. The private equity boom was fueled by dirt cheap debt, a bull market in stocks, a strong global economy, rising corporate profits, massive capital inflows into Private Equity, Sarbanes/Oxley Reporting Rules for Public Companies, and Strong Early Returns. Some of the big private equity firms include Blackstone, Carlyle Group, Kohlberg Kravis Roberts, Texas Pacific, Thomas H. Lee, Cerberus, and Bain Capital.

Website design By BotEap.comHistorical Private Equity Returns:

Website design By BotEap.comPast returns from large private equity funds have been very good, outperforming stock market returns. According to Fortune magazine during the 10 years to mid-2006 (the likely peak for PE) private equity returns averaged 11.4% vs. 6.6% for the SP500 stock index. The longer-term results (20 years) show that private equity investments have returned a 4% to 5% premium to public equity markets. Of course, these superior returns are achieved with significantly higher risk and an investment that is “locked in” for many years.

Website design By BotEap.comMy concerns about investing in private equity and future returns:

Website design By BotEap.com1. Debt has become much more expensive for leveraged buyouts. Cheap and abundant debt was one of the key factors that enabled the success of private equity firms. Private equity is often just a leveraged buyout (LBO) of companies. For the last 5 years, high-yield or “junk” debt was very cheap and traded at a very small premium to Treasury debt. In the last 6 months, junk bond debt cost premiums have increased significantly (from 3% to 8%) and the availability of high-yield debt has fallen dramatically due to the credit crunch. Future PE returns will suffer because of this higher cost debt and because they won’t be able to use as much leverage. Less leverage means lower returns for investors.

Website design By BotEap.com2. The economy is much weaker now. We may be in a recession right now. Recessions are often very bad for leveraged companies. Given the amount of debt these companies accumulate on their investments, these private equity investments carry a fairly high level of risk. Private equity firm Cerberus is struggling with its leveraged ownership of Chrysler and GMAC (home and auto loans, $589 million loss in 1Q08) in the current economic downturn.

Website design By BotEap.com3. There has been a massive growth in the number of private equity firms and the dollars of capital invested in private equity, all chasing the same deals and paying higher prices. Above average returns are almost always wiped out as tons of new supplies or capital enter the market. Acquisitions are now much more competitive and expensive. Private equity firms can no longer buy “cheap” companies with all competitors bidding on the same assets. Many of the big hedge funds have also gotten into the private equity business in recent years, making it an even more crowded space. More players chasing deals with lower returns just to “put money to work”?

Website design By BotEap.com4. Several large private equity firms have recently gone public. Why would they do that? That is inconsistent and hypocritical with his whole philosophy of how much better it is to run companies privately. Did you feel a “cap” in the private equity market? I think so. Industry “smart money” was selling, so why should we be buying? PE companies that went public have seen their shares drop significantly recently due to concerns about the private equity industry. Blackstone (BX) is one of the major players in the private equity business. Its shares have fallen more than 40% since it went public (at its peak) and its fourth-quarter earnings (announced on March 10) were down 89%.

Website design By BotEap.com5. Some of the private equity firms have recently had trouble landing big deals. Some large purchase deals have collapsed due to less attractive terms in the new environment, a slower economy, or an inability to obtain financing. Doing fewer major deals and on less attractive terms means lower future returns for private equity investors.

Website design By BotEap.com6. Private Equity firms seek out smaller, less profitable businesses out of necessity. Firms are now making small investments, making private investments in public companies (PIPEs), supporting small growth companies, and buying convertible debt. These types of transactions are likely to generate lower returns than the traditional large LBO transactions of the past. Blackstone boss James says “we’re looking at deals that don’t rely on leverage.” Harvard business professor Joshua Lerner says the term LBO is a bit obsolete when leverage and buying are not available. A lot of the big private equity firms aren’t able to find good investments, so they currently have a lot of cash, which doesn’t produce much of a return at all.

Website design By BotEap.com7. Commissions are too high for investors. Private equity fees are typically 2% per year, plus 20% of profits made. That’s very expensive, especially if they’re investing in cash, converted, PIPE, smaller, less leveraged businesses and the expected returns are significantly lower than in the past.

Website design By BotEap.com8. Access to the best private equity funds and companies is restricted. If you’re a small investor with only a few million to invest in private equity, it’s unlikely you’ll have access to the biggest or best private equity companies and funds. The past performance of a particular PE manager may not be a good indicator of future performance. You may have to settle for a less experienced private equity fund or “fund of funds” with an added layer of fees.

Website design By BotEap.comI think there will still be a place for private equity investment among the larger institutional investors, but the returns could be somewhat disappointing over the next 2-3 years for everyone. In my opinion, most individual investors should avoid this investment sector for now.