BILLIONS GUSHING INTO NEW FUNDS: LET’S BUY OURS! LBOS NOT JUST FOR RICHEST

Following the lead of big institutions — and hoping to top the market’s recent fat returns — wealthy individuals and higher income families poured billions of dollars into leveraged buyout funds in the first half.

While the superrich usually play the LBO game by coughing up as much as $25 million to gain direct access to funds, less affluent investors are turning to a growing number of funds of funds — some with minimums as low as $250,000.

Nearly two dozen firms are either marketing funds of funds that invest in private equity ventures, including LBO funds, or plan to roll them out.

“Investment banks, like Merrill (Lynch & Co.), have been asked by their wealthy clients for a way to get into private equity,” says David Toll, a senior editor for Private Equity Analyst newsletter.

But some individuals don’t understand the risks associated with such investments. They’ll suffer more than deep-pocketed institutions will if the funds don’t deliver the goods.

Indeed, the frothy LBO market appears headed for a slowdown because so much money is chasing a dwindling number of good deals. Then there’s the danger of an economic downturn.

Still, it’s not hard to see why so many people want a piece of the action. For the 10 years through March 31, buyout funds had an average annual return of 20.1%, compared to 18.4% for all private equity funds, says Securities Data Co. of Newark, N.J. Meantime, the Standard & Poor’s 500 stock index gained 18.9% annually.

Last year, the top 25% of buyout funds enjoyed a 33.7% internal rate of return, edging out the S&P, which gained 33.4%. And some of the most prestigious buyout firms tout internal rates of return exceeding 100%.

Because they face two sets of hefty fees, internal rates of return on funds of funds are typically one to one and a half percentage points less than the buyout funds in which they invest, although many haven’t been around long enough to establish a track record.

Through the first half of this year, 53 corporate finance firms, mostly buyout shops, raised $23.9 billion, according to Private Equity Analyst, published in Wellesley, Mass. That’s up 54% from the $15.5 billion raised in the first half of 1997 by 39 firms.

Even more staggering is the cash flowing into funds of funds: $5.5 billion at 18 funds during the first half , up 83% from $3 billion at 13 funds during the year-earlier period.

The buyout market has become so frenzied, says Ed Bagdasarian of Los Angeles-based investment banking boutique Barrington Associates, that recently one strategic buyer tried to submit a preemptive bid on a firm that manufactures coin-operated games even before Barrington had finished drafting an offering memorandum describing the company’s prospects.

Nonetheless, the prospective buyer lost out to a consolidator that two months ago paid 16 times earnings before interest, taxes, depreciation and amortization (Ebitda) for Mission Crane Service Inc. of Anaheim, Calif. The average multiple paid for such middle-market companies, explains Mr. Bagdasarian, is six to seven times Ebitda.

“They paid more than a publicly held strategic acquirer that was interested,” he says, adding that the firm was a hot commodity because of the consistent revenue stream from its games.

Congress gave the buyout market a boost two years ago when it passed legislation to increase the number of investors allowed in any one private partnership from 100 to 500 as long as they are “qualified,” meaning individuals with at least $5 million in other investments. Most buyout funds and funds of funds are structured as private limited partnerships, which, unlike public offerings, don’t have to register with the Securities and Exchange Commission.

“More and more investors are in an asset allocation mode and looking at the non-traditional, less liquid investment opportunities,” says Martin Jaffe, chief operating officer of high-net-worth manager Wood Struthers & Winthrop Management Corp.

The firm is part of the Donaldson Lufkin & Jenrette Asset Management Group, which has raised more than $2 billion through various funds of funds during the past two years.

“It’s (a function of) trying to get higher returns by going out a little more on the risk spectrum within a balanced portfolio,” says Mr. Jaffe, adding that his firm advises clients to have about 30% of their portfolios in private equity investments, such as LBO funds.

Of course, institutions have a huge head start in the private equity market. The country’s largest tax-exempt organizations last year committed $91 billion to alternative investments, up 57% from 1995, according to a study by Goldman Sachs & Co. and Frank Russell Capital Inc.

Nonetheless, 70% of the 213 institutions surveyed said “excess cash chasing too few quality investment opportunities is and will continue to be the most critical issue for alternative investors,” especially in the U.S. market.

Cautions Peggy A. Farley, president of New York-based Ascent Asset Management Advisory Services Inc.: “If the economy doesn’t continue to boom, companies that are start-up in nature or trying to do a turnaround have a harder time doing that and have a longer horizon before they are profitable. Or they may not succeed at all.”

Even the most legendary names can suffer setbacks. Earlier this year, Kohlberg Kravis Roberts & Co. ended its investment in the Bruno’s grocery chain, reportedly wiping out $250 million in partners’ capital in less than three years.

When New York-based KKR bought the foundering chain in 1995, it had a string of grocery successes under its belt. KKR brought in a new chief executive for Bruno’s, reportedly paying him a $1.2 million signing bonus, but competition in the chain’s Southeastern markets intensified and last year debt-burdened Bruno’s filed for Chapter 11 bankruptcy protection.

europe, here they come

A KKR spokeswoman did not comment, but the firm has recently set its sights on the European market, where more opportunities are expected to arise as companies go through the difficult adjustment to global competition. KKR has announced more than $3.2 billion in buyouts in Europe, including last week’s $1.7 billion acquisition of German paint company Herberts.

Charles Flynn, managing director of fund of fund products in the New York office of Paris-based Axa Investment Managers, dismisses the hoopla over so much cash in the U.S. market, saying it’s all relative.

Today’s buyout managers put up 30% equity, compared to only 7% in 1987, he says. “They are buying safer, offsetting the risks of higher prices and putting their money to work that much faster, which mitigates the risk of dry powder.”

Later this year, Axa plans to begin marketing two private equity funds, each with a goal to raise $300 million. The funds will be marketed to institutions, but the firm isn’t ruling out letting in individuals.

Yet even seasoned investors are beginning to get nervous. “We are concerned that there will be too many dollars chasing deals,” says William F. Quinn, president of AMR Investment Services, a $14.5 billion pension system in Fort Worth, Texas.

The fund has invested in some 10 private equity partnerships, including a $5 billion leveraged buyout fund being raised by Hicks Muse Tate & Furst. Hicks has already committed to $1.5 billion in deals and the fund hasn’t even closed yet.

Mr. Quinn admits that other buyout funds have had trouble finding deals — yet they keep collecting management fees while they look. Still, he’d rather they do that than invest hastily.

Small investors may not be as patient. Many buyout funds have a life span of a decade. There is a secondary market for limited partnership interests in buyout funds, but it can take years to fund a buyer and sales are often done at a discount.

“If you are not prepared to stay in the whole 10 years, maybe you shouldn’t be in it,” says John K. Castle, chief of Castle Harlan Inc.

The New York firm goes after little-known companies with big names in unglamorous industries — from airport baggage carts to deep-water oil ports. “It’s likely in the next five years that returns are not going to be that high,” Mr. Castle says, citing his $275 million fund’s average annual internal rate of return of 74% in the six years ended June 30.

Thinner returns may be especially painful given the hefty fees. Buyout funds typically charge a 2% annual administrative fee, but also take a 20% share of profits after investors get a certain return, or hurdle rate, usually 5% to 8%.

Funds of funds add their own fees, bringing total management fees up to 3%, with 30% of profits going to general partners after the portfolios hit their hurdle rates, according to Mr. Castle.

Says Mr. Toll of Private Equity Analyst: “There is a very wide margin between the best returns of the buyout funds and the worst.”