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.

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 per cent from 54 per cent during the same time period. However, in a Securities and Exchange Commission document filed in preparation for going public, Apollo officials wrote 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.

Bad news for two big investors

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

Apollo Global reported a US$96.4 million net loss in the quarter ended March 31, down from a US$144 million profit in the same quarter last year, according to the SEC filing. Kohlberg Kravis Roberts & Co. also suffered return declines, even in the Millennium Fund, a 2002 vintage fund. From inception in December 2002 through March 31, 2007, the Millennium Fund’s IRR was 40.6 per cent. Also, last quarter KKR suffered net unrealised losses of US$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 Fann, boss of PCG Asset Management, a private equity consulting and fund-of-funds management firm.

A number of pension funds invested in multiple funds. For example, in 2006 and 2007, CalPERs committed capital to KKR European Fund II and KKR 2006 Fund. 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.”

Still capital left

Jay Fewel, director of investments at 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,” 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 LBOs got higher in the second half of 2006 and into 2007.

Allocations by both the largest public and corporate defined benefit funds topped 5 per cent, as of September 30, 2007. Corporate DB plans had just edged up to 5.3 per cent of total assets from 5.1 per cent two years previously, but the largest public DB plans jumped to 5.2 per cent from 3.9 per cent during the same period, according to data collected in Pensions & Investments’ annual survey of the 200 largest US employee benefit plans. In total, the largest 200 retirement plans had US$285.5 billion invested in private equity as of September 30, 2007, of which buyouts comprised US$108.4 billion.

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

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 per cent to 75 per cent allocation to large and megabuyout funds — may have to work through a period of poor portfolio performance over the next several years,” 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 per cent from 1 per cent between the later 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.

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