Fast bucks

Taking full advantage of ultra-liquid debt markets, buyout funds are handing big sums of cash back to investors. As holding periods shorten, are limited partners in danger of getting too comfortable with private equity's new short-termism, asks Philip Borel.

Is this the golden age of LBOs?

Most practitioners active in the asset class are hoping that it isn't. Ages have a nasty habit of going into decline the minute people start calling them ‘golden’, and the notion that the private equity market may (finally) be about to turn is not helpful to anyone with new funds to promote or deals to close. At this moment in time, the buyout industry produces excellent results, and as far as fund managers and their investing clients are concerned, long may it continue.

Pick any relevant performance indicator, and you will likely be looking at confirmation that most buyout groups are delivering the goods.

For example: according to figures compiled by Thomson Venture Economics on behalf of the European Private Equity & Venture Capital Association (EVCA) and published in May 2006, European buyout funds generated a net pooled internal rate of return (IRR) of 13.7 percent in the 25 years to year-end 2005. This compares favourably with several benchmarks including the Morgan Stanley Euro Index, the HSBC Small Company Index and the JP Morgan Euro Bonds Index, which during the period returned 2.7, 8.7 and 10.7 percent, respectively.

Predictably, because private equity is notorious for the extreme performance differentials between the best- and worst-performing managers, the upper quartile segment of the buyout universe displays even better numbers within these statistics: the EVCA data shows that top-quartile LBO funds have produced a net return of 31.8 percent since the industry's inception in 1980.

EVCA's figures also confirm that the short-term performance of buyout funds has been particularly impressive and has boosted the industry's performance figures overall. In 2005, the one-year rolling IRR for all buyout funds was 31.7 percent net of fees (39.8 percent for the upper quartile), the highest oneyear figure on record since 1999.

Traditionally, private equity has been classified as a long-term asset class where investments can take years to mature. That is why shortterm performance figures based largely on unrealised investments are usually best handled with caution. However, this is no ordinary period for private equity.

In a phenomenon that is without precedent in the asset class, buyout funds are returning cash to investors at a very fast pace. As a result, recent vintage funds have galloped through the J-curve and delivered significant realised returns to limited partners early on in their lives.

According to research published by global fund of funds proprietor Pantheon Ventures earlier this year, LBO vehicles raised between 2001 and 2003 have been able to lock in exceptionally high IRRs by recapitalising portfolio companies quickly and using the proceeds to pay cash dividends to limited partners.

At a time of relatively modest IPO activity, refinancing has become the single most important exit mechanism available to buyout firms in North America and Europe. According to Dealogic, more than $40 billion worth of refinancings were completed in 2005, against $15 billion in 2004. Pantheon found that on average, European sponsors were refinancing their portfolio companies within 20 months of acquiring them; in the past, recapitalisations took an average of 29 months to materialise.

Neither has 2006 produced any signs of a slowdown yet. In the first half of the year, for example, European buyout heavyweight Permira completed a leveraged recapitalisation of New Look, the UK fashion retailer it acquired in February 2004 for £700 million.

According to a results statement from SVG Capital, Permira's largest investor, the 2006 transaction was the firm's second refinancing of the company, returning another 100 percent of cost to investors and bringing total proceeds from the investment to date to an astonishing 2.1 times cost – evidence that the capital market's appetite for leveraged paper remains as strong as ever.

New Look is by no means an isolated case. Numbers compiled by Private Equity Intelligence show that in 2004, 2005 and the first quarter of 2006, distributions made by global private equity firms comfortably outstripped their capital calls – despite the fact that new investment was also exceptionally active.

Unsurprisingly perhaps, many limited partners have mixed feelings about the rapid, recap-driven turnaround of capital in and out of buyout funds. “Distributions from LBO funds are very strong and very fast, which is fantastic. But the refinancing boom is something you have to watch,” says André Jaeggi, a managing director at Zurich-based fund investor Adveq.

Observers like Jaeggi urge caution for a number of reasons. First of all, and fairly obviously, recapitalisations tend to leave behind highly leveraged companies that may or may not be equipped to cope if economic conditions deteriorate. With interest rates now in the ascendancy, concerns over credit quality have become widespread. Over 90 percent of limited partners responding to a recent survey by Coller Capital predicted a negative impact on investment returns by the leverage multiples being applied to LBOs in North America and Europe, either in specific funds or for the industry as a whole.

Sponsors that have already taken their money out of a recapitalised portfolio company may not share these concerns, but the reputational damage that an aggressively refinanced LBO going under could inflict on its private equity owners should not be underestimated either.

Secondly, the wave of capital returning to base sooner than expected has prompted fierce activity in terms of new funds being raised, which in turn is putting managers under pressure to make new investments more rapidly. As Jaeggi notes, “this carries the risk of investment teams losing their discipline.”

With private equity fundraising at an all-time high, it is easy to see why some practitioners wonder where the asset class is headed. In 2005, private equity firms worldwide raised more than $250 billion. $42 billion of the total came from advisors and funds of funds, according to a survey by Watson Wyatt, which also said pension funds remained by far the largest provider of capital to the asset class.

So far in 2006, the fundraising frenzy has continued unabated. In the first six months of the year, according to Private Equity Intelligence, new funds added another $167 billion of equity capital to the industry's coffers.

These are exceptionally large figures, even if you take into consideration that a large portion of the money has gone to the multi-billion dollar mega funds raised by the likes of Blackstone, Texas Pacific, KKR, Apollo Management and Permira. Given the weight of capital pouring into new funds, questions as to the long-term sustainability of private equity's investment performance seem legitimate – especially if, as many commentators are suggesting, the economic climate and capital market sentiment are about to worsen.

Sceptics argue that there is a distinctly bubbly feel to the business, as established limited partners come back for more and new investors pile in for the first time. They also point to the recent arrival of new funds listed by KKR and Apollo on the Euronext Stock Exchange in Amsterdam as evidence that demand for private equity products may be too keen for comfort, questioning whether those who subscribed to these quoted funds did in fact fully understand their performance characteristics.

To be sure, few practitioners are prepared to go on the record and call the top of the market. Says Dominique Mégret, chief executive officer at PAI Partners in Paris: “We always prepare for tougher times, but thus far they haven't come. One cannot know if the market will turn back one day.”

What's more, practically no one familiar with the asset class foresees a systemic shock that could suddenly sideline private equity as an increasingly mainstream component in institutional investment portfolios.

Still, it is not clear for how long private equity can continue to generate superior returns at the breakneck pace at which it has been moving of late. When the capital markets slow, limited partners who have become too comfortable with private equity's new short-termism may need to get to grips with longer holding periods and therefore lower IRRs. To novices in the industry, this may come as a disappointment.

Neither is it easy to predict how new funds raised today will perform in the years to come. But it is no coincidence that investment performance and fundraising are at a peak at the same time. “Pension funds and advisors tend to invest when current returns are high,” notes Josh Lerner, private equity specialist at Harvard Business School. And with close to 100 percent of limited partners canvassed by Coller Capital planning to either maintain or increase their exposure to private equity in the coming year, it is tempting to question the wisdom of the allocation decisions underpinning these plans.

All that said, investors approaching private equity with realistic performance expectations and investing steadily through the cycle should find the going relatively smooth – especially if they have access to experienced managers. In a paper published in 2005, Lerner and his MIT colleague Antoinette Schoar found a significant positive correlation between IRR and “fund sequence number”, suggesting that general partners tend to get better at what they do from one vehicle to the next – provided that this transition is not accompanied by a dramatic increase in fund size (see charts).

With many investors focused on the potential returns of private equity at the current point in time, general partners are weighing how much risk is required to deliver appropriate results. They also ponder the exact meaning of the word ‘appropriate’.

Mégret at PAI makes the point that it is now common place for professionals involved in the business to think about private equity performance in terms of relative returns, as opposed to some absolute target. And on a relative basis, few GPs have any doubt that they can continue to garner compelling results for their clients.

Says Philippe Audouin, chief financial officer at listed private equity group Eurazeo in Paris: “Structurally, private equity is one of the few activities that can deliver above market returns. But buy cheap, sell high doesn't happen. Performance is down to value creation nowadays.”

At this moment in time, value creation and expert financial engineering go hand in hand in private equity. Exactly which levers equity sponsors will pull when refinancings lose some of their current effectiveness is one of the most interesting questions about the future of the industry. Depending on the answer, the industry's golden age could continue for a long time to come – or else provide added weight to those who believe that golden ages are, by their very nature, ephemeral.