Capital Markets

King-Size PE Funds Underperform

Buyout funds larger than $4.5 billion lost 31.4% over one year and 3.1% over three years, raising caution among investors, says Preqin.
Vincent RyanJanuary 13, 2010

Large companies looking to be scooped up whole by financial sponsors may find fewer bidders with the necessary purchasing power in 2010.

An analysis of private-equity fund performance released Tuesday shows king-size buyout funds performing poorly compared with midmarket and bite-size funds. That is making investors wary about investing in such large vehicles.

“Megabuyout” funds ($4.5 billion or larger) proved the worst investments over one-year and three-year spans ending in June 2009, according to alternative asset research firm Preqin. The funds lost 31.4% in one year and 3.1% over three years. In contrast, small buyout funds ($500 million or less) provided the best returns over one and three years — or at least smaller losses — returning -12.9% and 18.6%, respectively. Midmarket buyout funds ($501 million to $1.5 billion) were the second-strongest performers, returning -16.7% for one year and 12.2% over three years. Over five years, the funds had the highest returns, 29.3%, followed by megabuyout-fund performance of 23.9%. Small funds returned 21.5%.

Preqin’s return data is based on a PE fund’s cash flows — how much capital limited partners contribute to a fund versus the proceeds they receive — plus the valuation of remaining investments. Fund values are depressed in the early years of a fund because management imposes its fees and expenses for identifying and acquiring initial investments.

But returns are also dented when there is a narrowing between the equity capital spent by buyout firms and a deal’s total value as a result of reduced availability of leverage. “While the effects of the financial crisis have been felt across the whole of the buyout industry, it is the very largest funds that are most affected,” says the Preqin report. “With the very largest firms being heavily reliant upon highly leveraged deals, it is unsurprising.”

The one-year performance of megafunds is making investors wary. In a separate study in December, Preqin found that limited partners were less keen to invest in megasize funds. Of the 100 investors surveyed, 37% said they would be avoiding the funds after having previously invested in them, and only 9% said they would be investing in such funds this year.

Six megabuyout funds closed in 2009, raising a total of $46 billion, with an $8.8 billion fund from Hellman and Friedman and a $5.5 billion fund from Clayton Dubilier and Rice notable. But that was less than half the $113 billion raised by 11 megafunds in 2008. In contrast, about half of all buyout funds closed in 2009 were in the small category; however, they made up only 10% of committed capital. Fundraising by buyout funds was lower in the aggregate, with $102 billion in capital committed last year versus $233 billion in 2008, Preqin says.

The Boston Consulting Group famously predicted last year that 20% to 40% of the largest PE firms would disappear in the wake of the banking crisis, due to subpar performance affecting capital-raising efforts. But Preqin thinks megabuyout firms won’t be on the mat for long, helped by improving fund valuations and debt markets.

“The value of the megafunds should increase — the one-year performance as of June 2010 will be positive, based on early looks at data from the September 2009 quarter, although it’s too early to tell by how much,” says Tim Friedman, a Preqin spokesman.

Complicating matters, though, will be the first tranches of debt on many highly leveraged funds coming due in 2011 and 2012 in what will be a tougher lending and regulatory environment than when the loans were originated.

With the lack of capital in the United States, many large PE firms have decamped for emerging markets to raise money and invest. This week Carlyle Group, which raised a $10 billion buyout fund in 2005, announced a much smaller, yuan-denominated fund in conjunction with the Beijing government, designed to invest in domestic Chinese companies. That follows a fund set up by Blackstone Group last August that is targeting investments in Shanghai.


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