Is private equity past its prime?

Private equity, the business of using debt and a sliver of equity to take companies private, borrowing to extract big fees, and multiplying the equity through an IPO or acquisition, is getting long in the tooth. Similar to the venture capital boom of the 1990s, private equity is attracting scads of new money from traditional and retail investors, it’s stretching outside its comfort zone to find big deals into which it can pour the new cash; it’s suffering more busted IPOs, and its supply of cheap debt is drying up as credit quality falls and interest rates rise.

To be fair, private equity returns were great last year, with Cambridge Associates’ private equity index rising 27% compared to 5% for the S&P 500 (including dividends). But the trends outlined above suggest it will be harder to achieve these returns in the future. Here’s why:

• New money. With fundraising up 43% in the first half of 2006, the private equity industry this year will easily blow past the $151.8 billion raised in 2005 and may even surpass the record $177.9 billion raised in 2000. And money is flowing into private equity from retail investors as the Wall Street Journal [subscription required] today highlighted -- retail mutual funds are investing in private equity from T. Rowe Price, Morgan Stanley and Deutsche Bank. Back in the dot-com days, I sensed a peak was coming when in December 1999 venture capital firm Draper Fisher Jurvetson launched meVC, a retail mutual fund for venture capital. I wonder whether history will repeat itself with private equity.
• Stretching for deals. The recent deals to take private HCA and Philips Electronics’ semiconductor unit suggest that firms are struggling to find deals big enough to put all the capital to work. While HCA had a successful round trip in the past -- HCA's ratio of debt to earnings before interest, taxes, depreciation and amortization may more than double to six times after the buyout – suggesting that there is little margin for error to make this $33 billion deal work. And with the high capital intensity and rapidly changing technology in the semiconductor business it is difficult to see how KKR and Silver Lake Partners will be able to generate attractive returns at the $10.2 billion they’re offering after winning a brutal bidding war. If these deals don’t work out, the lower returns will make it tough to raise funds in the future;
• Busted IPOs. Two recently busted IPOs could make it harder for private equity firms to find the exits. Bain Capital and others lent Vonage (VG) $200 million before taking this money-loser public. VG has lost 62% of its value since the May 2006 IPO. That same month Bain Capital and others took a $30 million “management termination fee” out of Burger King (BKC) before taking it public. (This fee is chump change compared to the $367 million dividend Bain Capital and its partners extracted from Burger King in February.) BKC has tumbled 26% since its IPO and it just announced that it lost $9 million in its fiscal fourth quarter due in part to the management termination fee. Investors will lose their appetite for private equity IPOs if there are more such busted deals;
• Rising interest rates. With the Fed having raised interest rates from 1% to 5.25% since June 2004, the cost of borrowing has risen dramatically. Moreover, the borrowing rates that private equity investors must pay are higher than they’ve been in five years. For example, in the HCA deal, the investors will pay 2.15 points more than the London Interbank Offer Rate (LIBOR) – which last reached its current level in early 2001. With the credit ratings of LBO debt declining and LIBOR rising as the Fed tries to squelch inflation, private equity borrowing costs will rise – making it more difficult for them to find businesses which generate sufficient cash to pay off lenders and still maintain that sliver of equity on which private equity returns depend.

If private equity is indeed peaking, there’s nothing to worry about. Top hedge funds managers are still enjoying their average $363 million annual compensation. Unless hedge funds are in trouble too…