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

During that two-year period, investors committed US$301 billion to private equity funds, according to Cambridge Associates data. But the credit market retraction has slowed private equity transactions to a flicker and all but extinguished investor hopes that some of their investment will yield the 28-30 per cent returns of earlier top-performing funds.

The result is that investors committed the most capital to funds 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 officer at Stepstone Group, an 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 to the US$301 billion raised between 2005 and 2007, only US$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,” 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 month, executives at top buyout firm Apollo Management 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.

Net IRR for Apollo’s sixth fund, Apollo Investment Fund VI, dropped to 21 per cent in the period from its first investment in July 2006 to March 31, 2008 — a sharp decline from the 42 per cent IRR reported for the period between July 2006 and December 31, 2007.

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