Private Equity return expectations sag

As go the leverge markets, so too go private equity return expectations.

Over the past few months, I’ve been hearing a constant chatter about traditional PE firms “walking down” their LPs’ return expectations for the coming years. If the 2005-vintage tone had been 24% IRRs across an entire portfolio, now folks are talking about 18%. If an infrastructure fund murmured about 13%-14% returns, those figures have pulled back to 8%. Unscientific, yes, but the datapoints cover the waterfront: GPs, LPs and pension advisory firms alike.

The timing makes sense, after a few stellar years of leverage availability and a willing capital markets for quick takeouts. Think about the conversion cycle of Shoppers Drug Mart, Yellow Pages, BFI, Lululemon, etc. Do a private deal, tack on the debt, shake and stir, and bring it back out. Even without the income trust market for Canadian exits, the GPs weren’t worried about their ability to continue hitting the ball out of the park.

Until, it appears, this summer. Fair as it might be to point fingers at the credit markets, the 25 year PE returns are pretty consistent, according to friends in the know. What has changed, then, other than a less vibrant credit market?

Fund sizes, that’s what.

If you were managing a $200 million PE fund circa 2001, you’re now managing $400 million. $400 million funds have grown to $650 – $800 million, and so on.

The impact of the increased sizes, compounded by an absence of the income trust market for pretax takeout valuations, is pretty clear: higher annual management fees are likely to produce a longer j-curve and a lower overall net return to LPs.

Do the math for yourself: Jill Buyout used to manage a $400 million fund, with a 2% management fee generating $8 million a year for staff, office rent and marketing; on an 8 year fund the management fees amounted to $64 million.

Jill’s new buyout fund is $750 million, and she’s hired an extra four professionals to help her manage and close the deals that the increased firepower will produce. Unfortunately, many other funds have also grown their sizes in a similar way, meaning competition hasn’t diminshed even though her “sweet spot” deal is a bit larger than in her old fund.

With a $7 million increase to the annual management fee, but new costs of just $500k per hire ($2 million all told), Jill has $5 million more to spend on office space, marketing, a Net Jets card, and still pocket more when all is said and done. The 8 year management fee just ballooned from $64 million to $120 million in aggregate.

If the macro dynamics of the market (no income trusts) aren’t delivering higher valued exits, then Jill’s limited partners can’t hope to replicate the returns experienced in the last fund, even without the increased management fee (the 1st hit). Tack on the additional $64 million of aggregate management fees, and the wheels start to come off the business model (the 2nd hit).

And that assumes the LPs put their money in directly. If they hired a fund of fund manager to pick the wheat from the chaff, that’s a triple hit to their net returns.

If PE firms need the ability to grow cost-effectively, I’d recommend a recirculating structure – just as we have at Wellington Financial. If a deal gets successfully sold within the first three to five years of a fund’s life, why give the LPs their original capital back? Assuming that everyone is pleased with the GP’s performance, LPs should take their profits from the early success, but let the GP reuse the original capital a second time. In the long-life 8-10 year fund structures of today, it makes total sense.

If LPs are unhappy with the GP’s numbers, the “no-fault divorce” clause is their protection from a recycling of capital that’s against their wishes. But if it could keep fund sizes down even 15-20%, it should mean shorter j-curves for LPs, less leakage of the 2% management fee, and ultimately improved net returns.

And nothing could be better for the PE business in the long term than a simple structural adjustment that fixes the two upcoming challenges of institutional investors: longer j-curves and lower returns.

I asked a panel of pension fund CEOs at the recent Thomson Buyout/Mezz conference if they’d ever consider such an approach: the boss from Alberta Investment Management had the honesty to say “I’ve never thought of it before, but it sounds interesting.”

Relying on the credit and equity markets to generate the returns promised to LPs in 2005 and 2006 is proving to be difficult. This is the only solution – other than praying – that’s entirely within the private equity industry’s control.

Getting fat on the 2% will hurt the next generation of PE fund managers, just as poor VC returns over the past half decade are making life very hard for the talented VC fund teams currently in fundraising mode.

MRM