Weak vintages may leave vinegar taste

Private equity was on fire in 2006 and 2007, but investors who fueled the record fundraising then might still get burned.

During that two-year period, investors committed $301 billion to private-equity funds, according to data from Cambridge Associates LLC of Boston. But the credit market retraction has slowed private-equity transactions to a trickle and all but extinguished investor hopes that their investments will yield the 28% to 30% returns of earlier top-performing funds.

The result is that investors committed the most capital to funds that are now expected to produce the lowest returns in years. Investors might not even get back the capital they invested in a number of these funds.

“For 2006 and 2007 vintages, we will not see the returns we did in prior years,” said Monte Brem, chief executive of Stepstone Group LLC, a San Diego-based alternative-investment consulting firm. “It’s still too early to tell, but it is likely there will be some funds that will struggle to return capital on their 2006 and 2007 vintage funds.”

In comparison with the $301 billion raised between 2005 and 2007, only $192 million was raised from 2000 through 2004.

More than any other asset class, private-equity investors rely on past returns to determine future investment with specific managers. And for many investors, that resulted in large concentrations in the large brand-name funds. Overexposure to the large buyout funds could infect the returns of entire private-equity portfolios, some industry insiders said.

“In the private-equity asset class, past returns of a manager tend to be an indicator of future returns,” Mr. Brem said. “This is referred to as persistence of returns, and is more prevalent in private equity than other asset classes. The effect of following this strategy is that funds that do well stay in your portfolio, these funds continue to get larger in size, and your portfolio becomes overconcentrated in large funds.”

Just last week, executives at top buyout firm Apollo Management LP of New York cautioned investors that its current funds are unlikely to produce returns up to its historical standards. In the quarter ended March 31, Apollo lost money on all of its private-equity investments.

The net internal rate of return for Apollo’s sixth fund, Apollo Investment Fund VI, dropped to 21% in the period from its first investment in July 2006 to March 31, 2008 — a sharp decline from the 42% IRR reported for the period between July 2006 and Dec. 31, 2007.

The net IRR for its prior fund — Apollo Investment Fund V, which invested its capital during the economic downturn of 2001 through late 2003 when a number of buyout funds did well — dipped slightly to 52% from 54% during the same time period. However, in a Securities and Exchange Commission document filed in preparation for going public, Apollo officials wrote that investors should not expect similar returns from future funds.

“We do not believe our future IRRs will be similar to the IRRs for Fund V,” the firm states.

This is particularly bad news for two large investors. In July 2007, the $900 billion Abu Dhabi Investment Authority, based in the United Arab Emirates, and the $227.7 billion California Public Employees’ Retirement System of Sacramento each bought a 10% stake in Apollo Global Management LLC of New York, the manager’s parent, for a combined $1.2 billion. As part of the deal, they agreed not to sell the stakes for two years. In addition, CalPERS committed $1 billion to Apollo’s seventh buyout fund as well as capital to the two other funds.

Apollo Global reported a $96.4 million net loss in the quarter ended March 31, down from a $144 million profit in the year-earlier period, according to the SEC filing.

Kohlberg Kravis Roberts & Co. of New York also suffered return declines, even in the Millennium Fund, a 2002 vintage fund. From inception in December 2002 through March 31, 2007, that fund’s IRR was 40.6%. It dropped to 27.4% for the period from inception through March 31, 2008. KKR does not provide return information for funds younger than 36 months.

Also, last quarter KKR suffered net unrealized losses of $2.2 billion from changes in the market values of the portfolio companies in its private-equity business.

Not only was there a boom in fundraising between 2005 and 2007, but the megafunds went to the marketplace a couple of times during the time period.

“People invested very quickly. Some 2006 funds were invested by 2007,” said David I. Fann, president and chief executive officer of PCG Asset Management LLC, a San Diego-based private-equity consulting and fund-of-funds management firm.

A number of pension funds invested in multiple funds. For example, the Tigard-based Oregon Investment Council, which oversees the $60.6 billion Oregon Public Employees’ Retirement Fund of Salem, committed $1.3 billion to KKR Millennium Fund II and $187.5 million for a co-investment with KKR in the first quarter of 2007. In the following quarter, the Oregon Investment Council made a commitment to KKR Asia and in the fourth quarter committed to KKR Europe Fund III.

Similarly, in 2006 and 2007, CalPERs committed capital to KKR European Fund II LP and KKR 2006 Fund LP.

But CalPERS officials say it is too early to be concerned about the 2006 and 2007 buyout funds.

“These funds are too young for any meaningful assessment of performance,” said spokesman Clark McKinley. “You may have noticed that the youngest funds have often negative returns for the early years of what’s typically a 10-year fund lifetime [or longer] before we cash out. It may take three to five years for funds to draw down CalPERS’ committed capital. It’s just too early to tell how this might pan out.”

Jay Fewel, director of investments for the Oregon Investment Council, called dire predictions about the 2006 and 2007 vintages “speculation” because most have quite a bit of capital yet to invest. It depends on how the economy fares, he said.

“You always have too much in good-performing investments and not enough exposure to bad-performing investments,” Mr. Fewel quipped. He added: “We have considerable exposure to those years [2006 and 2007], but ask me again in the next couple, three years.”

Meanwhile, institutional investors chased returns, increasing their allocations to private equity, industry insiders said. At the same time, prices for leveraged buyouts got higher in the second half of 2006 and into 2007.

Allocations by both the largest public and corporate defined benefit plans topped 5%, as of Sept. 30. Corporate DB plans had just edged up to 5.3% of total assets from 5.1% two years previously, but the largest public DB plans jumped to 5.2% from 3.9% during the same period, according to data collected in Pensions & Investments’ annual survey of the 200 largest U.S. employee benefit plans. In total, the largest 200 retirement plans had $285.5 billion invested in private equity as of Sept. 30, of which buyouts comprised $108.4 billion.

The largest endowments, those with more than $1 billion in assets, increased their average private-equity allocation to 7.1% in fiscal year 2007 from 5.7% in fiscal year 2006, according to the 2007 and 2006 surveys done by the Washington-based National Association of College and University Business Officers.

Some of these investors may be struggling with low private-equity performance over the next several years.

“Limited partners that overcommitted to the 2006-2007 vintage years and to large funds during this period — for instance, those who dramatically increased commitments to 2006-2007 vintages and had a 65% to 75% allocation to large and megabuyout funds — may have to work through a period of poor portfolio performance over the next several years,” Mr. Brem said.

But they won’t suffer alone. General partners committed a greater portion of their own capital to funds raised during the period. Industry insiders say that brand-name managers increased their commitments to their funds to as high as 5% from 1% in the latter part of 2006 and into 2007. However, managers, such as KKR, have lowered their overall risk by selling stakes in their firms to sovereign wealth funds, institutional investors and the private- and public-equity markets.

Arleen Jacobius is a reporter for sister publication Pensions & Investments.