Academics predict negative returns for ’05, ’06 funds

Increasing fund sizes and periods of heavy fundraising have historically correlated with decreasing returns, according to research presented by two prominent US scholars.

Vintage 2005 and 2006 funds will produce disastrous returns, predicted two private equity scholars yesterday.

Speaking at a Washington DC conference sponsored by conservative think tank the American Enterprise Institute, Harvard Business School professor Josh Lerner and Steven Kaplan, of the University of Chicago Graduate School of Business, said that analysing three decades’ of industry trends leads them to believe that periods of frenetic fundraising activity are associated with steep declines in returns.

Drawing parallels between the frenzy of fundraising in the early 1990s as well as at the height of the dot-com bubble, Kaplan said 2005 and 2006 funds “will likely disappoint”. Using a regression analysis, Lerner predicted that 2006 vintage funds should return around -19 percent to limited partners.

Even on a firm-by-firm basis, empirical evidence shows that raising bigger funds leads to a decline in returns, Lerner said.

Both professors presented research examining industry metrics since the early 1980s until the present, and drew comparisons between the credit market-related turmoil of recent months and previous boom and bust cycles in the private equity industry.

“In the 1980s the very largest groups suffered the largest declines in returns,” Lerner said. He pointed out that the major players in the industry today, such as The Blackstone Group and Kohlberg Kravis Roberts, dwarf those of the 1980s, increasing potential losses should the economy experience a downturn.

Lending ominous support to these predictions, Kaplan said, is the fact that so many private equity firms chose to go public this year.

“These [GPs] are very smart people who typically don’t sell when prices are low,” Kaplan said.

However, Kaplan and Lerner both said the industry has changed in major ways since the last two private equity boom periods, which could mitigate their gloomy forecasts.

Private equity firms are more focussed on “operational engineering” today, they said. Firms now often employ operational executives or operational consulting groups to improve the value of a portfolio company, rather than simply earning money through financial engineering, making them less vulnerable to economic cycles.

Deal structures are also less fragile, Lerner said. Compared to the 1980s, debt levels are lower and earnings to interest rate ratios are lower. In the event of an overall economic downturn, Lerner said he expects to see fewer defaults among portfolio companies.