An examination of the 1998 vintage year for buyout funds shows weak returns, on average. But the so-called credit crunch of that year had little to do with this underperformance. Those worried about the performance of the current vintage year should pay more attention to the economy and to the skills of individual GP groups, reports David Snow.

Private equity's “golden era” has been declared over by the mainstream press. Judged by these reports, you'd think that limited partners got involved in this asset class simply because mega-deals are a lot of fun.

In fact, what LPs care most about are returns, and if private equity firms can do well deploying large amounts of capital, all the better. And while not totally divorced from performance, size and pace will be most impacted by the current bout of debt indigestion. These deal flow dynamics are distinct from performance, doomsday predictions notwithstanding. The somewhat distracting coverage of mega-deal making was best summed up by Henry Kravis, who earlier this year told the Wall Street Journal: “Any fool can buy a company… You should be congratulated when you sell.”

Fools and sages alike have a hard time predicting when a cycle is about to turn. The noxious and widespread effects of the sub-prime mortgage meltdown have taken many in the private equity market by surprise, just as the Russian crisis of 1998 caught the buyout market off guard. It is unclear when the current turmoil will right itself, or how it will further morph. And of course, no one can predict ultimately what effect this credit crunch will have on deals done leading up to it, and on deals done in its aftermath.

It may be instructive, therefore, to take a look at the performance of buyout funds from the vintage year 1998, which qualifies for the exercise both because that year suffered a bona fide credit crunch of its own as well as because the nine years that have passed since give more weight to the performance figures, provided by PrivateEdge (see charts on this and following pages). Will 2007 be another 1998 – a year of debt market turmoil presaging generally weak performance? The answer, according to industry veterans, hinges more on the coming performance of the economy than on the details of the current crunch.

The private equity market of 1998 does resemble 2007 in many ways. It was a year of record-breaking fundraising and deal-doing activity, although the sizes seem quaint by today's standards. In the US, for example, buyout and mezzanine funds raised nearly $55 billion, a 58 percent increase over the 1997 fundraising numbers, according to Thomson Financial. The year also saw roughly $41 billion in completed US buyout deals, a more-than 40 percent jump over the prior year.

The first half of 1998 also saw great exuberance in the debt markets, especially in the high yield market, driven largely by LBO activity. Price multiples were increasing as debt-to-EBITDA multiples expanded. Coming out of 1997, large buyout deals were averaging 5.7 times EBITDA in debt, according to Standard & Poor's LCD.

Then in the late summer of 1998, a financial crisis emanating from Russia spread through the bond markets and brought the LBO industry to a standstill, causing many deals to get shelved. “What tends to happen in a credit crunch is that you get a slowdown in deal activity, the froth gets knocked off the market, multiples of EBITDA come down and covenants get tighter,” says Tom Lamb, the Londonbased co-head of private equity for Barclays Private Equity. “Deals done pre-crunch tend to be highly geared and highly priced. Post-crunch, there are lower prices, less competition, less leverage.”

It wasn't until December 1998, with the sale of high yield bonds to support Bain Capital's acquisition of Domino's Pizza, that market watchers began to see a return to normality. However, what followed was three years of contracting debt multiples, accompanied by contracting purchase price multiples. By 2002, large buyout deals were averaging 4 times EBITDA.

Of course, the credit crunch of 1998 turned out to be a mere road bump on the way from the exuberant late 1990s LBO market to the nadir of a global economic slowdown post-2000. Notably, the technology, internet and telecommunications spaces crashed. And in the midst of this was September 11. By the trough of 2002, the blip of 1998 was all but forgotten amid a sea of subsequent bad news. But many of the buyout funds launched in 1998 were already showing themselves to be especially poor performers.

Today, a look back at 1998 confirms that the vintage year was, for all buyout funds (in the US, Europe and elsewhere) the worst of all buyout vintage years tracked by PrivateEdge since 1990 (not counting the J-curved recent vintages). Buyout funds of the 1998 vintage have turned in to their investors, on average, a net IRR of only 5.95 percent, according to PrivateEdge, a division of State Street. This compares poorly with the pooled average of all buyout funds (which blends all vintage years tracked) of 15.48 percent. The year 1998 also compares very poorly with the two vintages that sandwich it, although this isn't saying much, since both are less than 12 percent.

Clearly, a critical mass of buyout funds raised in 1998 suffered the double whammy of paying top prices for highly leveraged companies in the months leading up to the credit crunch, and then continuing to invest leading up to a recession and tech crash. While the debt market prior to the current credit crunch was even frothier – with large deals averaging 7 times debt-to-EBITDA ratios – a recession one or two years from now would have a more material impact on the funds of 2007 than will the debt market correction.

“What is fundamentally different this time around is that what we've seen was a debt bubble, not an equity bubble,” says Thomas Kubr, the chief executive officer of private equity asset management firm Capital Dynamics. “Spreads are back to where they were two years ago, but two years ago they were already comparatively low.”

Make no mistake – average returns will likely come down. Kubr says that the cheap and plentiful debt of recent years has driven returns to unusual highs, and that a less buoyant debt market will certainly have an impact on returns. And although there is typically a counter-effect to this in the form of lower purchase-price multiples, Kubr says he believes that the effects of less leverage tend to outweigh the effects of lower prices. “If you have previously invested 30 percent equity and now you have to provide 40 percent equity, you have increased the amount of equity by one-third,” explains Kubr. “Whereas, for example, if there's a price decrease of 10 percent, the effect on returns would be smaller.”

While returns are expected to come down as a result of there being less leverage and lower exit multiples, the real worry is that certain general partners will not have adequately factored such a scenario into their investment plans. This, coupled with a possible economic slowdown or recession, will certainly result in mediocre returns and busted portfolio companies for those managers.

Erik Hirsh, the chief investment officer of Philadelphia-based investment advisor Hamilton Lane, notes that smart GPs evaluating paying, say, a 10 or 11 times multiple for a portfolio company will try to model out the projected returns based on a much lower multiple on the exit to see if the investment still makes sense in that scenario. “But not everyone does this,” says Hirsh, noting that his firm's co-investment programme has given Hamilton Lane greater insight into the due diligence methods of different GP groups. “We're seeing which GPs are being conservative and which are being really aggressive.”

This performance data is part of the new State Street Private Equity Fund Index provided by Private Edge, a fund administration and data services division of State Street. This performance data is calculated based on the cash flows of State Street's clients, the limited partners. In order to capture the true market weight of underlying funds, The State Street Private Equity Fund Index has calculated a return based upon an approximation of the total cash flows and market value of the underlying funds found in the Index. In order to do this, PrivateEdge has approximated the total fund cash flows and market values by dividing the limited partner cash flows by their commitment percentage of the fund. The data is based on an analysis of more than 1,200 partnerships.

In the event of a sustained market downturn, a lowering tide will affect all GPs no matter how fit their respective ships. “It's not the debt. We are much more interested in the valuations of the stock markets right now.” says Kubr. “If stocks were to crash by 20 or 30 percent, then we've just lost 20 to 30 percent of private equity value. That would really be the noteworthy event of this cycle.”

Still, Kubr remains bullish on the long-term prospects for private equity returns, even if it turns out that a combination of factors mars this or adjacent vintage years. “It would be totally unrealistic to believe that the returns of the past few years are sustainable,” he argues. “There is a lot of cushion left before private equity becomes unattractive compared to public equity markets. As long as we have IRRs in the midto high-teens, private equity is a great performing asset class.”

An era of gigantic deals has come to an observable pause. The story that will take longer to tell is how these deals and the deals done in the coming months will perform. As Lamb puts it: “Deals being done – that's not a boom. The boom is the returns.”