PE Managers Predict Two Years of Healthy Returns

Despite a challenging capital-raising environment and growing worries about new government regulations, private equity firms are guardedly optimistic about fund returns and see strong investing opportunities in specific U.S. vertical industries. 

Those views stem from the results of a new quarterly CFO benchmark survey done in partnership with the Rothstein Kass: the Rothstein Kass/CFO Midsize Private Equity Firm Barometer. The survey, conducted in January 2012, polled 90 private equity firms with assets under management ranging from $150 million to $1 billion.

4 Powerful Communication Strategies for Your Next Board Meeting

This whitepaper outlines four powerful strategies to amplify board meeting conversations during a time of economic volatility. 

Download the whitepaper

Fund valuations have shown resilience in an uncertain economic environment, said PE managers responding to the survey. Despite a volatile stock market and concerns about the European debt crisis, more than half of the PE managers that responded to a question about their investment valuations said their portfolio assets had increased in value since the last reporting period; only 5.6% of the fund managers reported that their portfolio valuations had fallen.

“Private equity firms have withstood stormy economic conditions in part by finding value in middle-market companies in every business sector,” says Jeff Somers, a principal at Rothstein Kass, a provider of professional services to alternative investment firms. “They have also taken on more active roles in the management of portfolio companies to unlock the latent value of these enterprises. And many firms have successfully relied on specialized sector expertise to find investment opportunities and streamline portfolios.”

For a year in which the S&P 500 returned 2.1%, private equity managers expect their funds to post strong relative returns for 2011 once the final numbers are calculated. Among the survey respondents who provided 2011 projections to Rothstein Kass, the average expected return was 17%. For 2012, respondents expect modestly improved performance, 18% on average. But for 2013, the average anticipated return jumps to 22%.

“The climate in Washington has been cited as a cause of prolonged economic malaise and the resulting uncertainty has been weighing on private equity firms as well,” says Rothstein Kass’s Somers. “That could be the reason that managers expect relatively flat returns this year, with more significant upside following the 2012 election.”

When asked which sectors will provide the most value to PE funds in 2012, PE managers had a wide range of responses. But industrials, healthcare-related businesses, and banking and finance lead the pack.

“Though many funds are weighted toward a particular industry, private equity is mainly industry agnostic,” says Somers, “so it’s very interesting that firms are seeing opportunity in industrials and financial services.” Somers says it suggests private equity firms are mildly optimistic about the near-term economic outlook, as these sectors will fare relatively well as the economy expands.

Raising the money to invest in those hot sectors has not been easy, however. Fund-raising and new fund launches remain slow, according to PE managers. Despite persistent reports of fee pressure from limited partners, though, 85.6% of the PE managers polled expect their fee structures to stay the same.

But the shadow of government regulation weighs heavily. An overwhelming majority of the funds, 84.4%, indicated that pending regulation would be a drag on their business going forward. Answers varied about which kinds of regulation would be most problematic. About 42% of the respondents said that new disclosure requirements like the investment adviser registration requirement under Dodd-Frank would be the biggest hurdle, while 30.3% of the respondents were worried that an overall increase in regulation would make it harder to do deals. Another 27.6% said that salary increases for compliance and legal personnel to deal with any new regulations would be a hindrance to future success.

A majority of PE managers are resigned to what could be the largest change for the industry — a reform of the tax treatment of the profits general partners receive as compensation. About 52% of survey respondents said there will be changes to the tax treatment of carried-interest in the United States, perhaps with some modifications to current proposals;  only 23.3% expect attempts at reform to be defeated.

“Carried interest taxation has loomed on the horizon for what might seem like an eternity to most managers — without any clear sign of a resolution,” says Somers. “This survey was completed just as a spotlight was cast on the industry in relation to the current election cycle. It will be interesting to see how the heated rhetoric will shape perceptions.”

Private equity seems to be at a tipping point heading into 2012. While there is evidence of increased positive sentiment, clearly a number of challenges could stall the sector’s recovery, says Somers.

Under a partnership with CFO, Rothstein Kass collected data for the Midsize Private Equity Firm Barometer in January 2012. The survey polled managers at 90 private equity firms — 81% of the funds polled have been in operation more than five years.