While the attention paid to older assets might appease investors in the 2006 vintages, it won’t benefit those in the later fund, who paid fees to see their capital used to pump life into troubled assets. Despite the harsh market, most managers persistently sought investment opportunities and worked on portfolio companies. Few chose to return uninvested capital to clients. But Hunter observed as one firm, which raised US$300 million in 2006 for its second institutional fund targeting small companies, gave capital back to investors after making just two investments that absorbed 20 per cent of its capital. The first investment, in a tanning salon, was ill-fated due to disagreements between business partners. The second investment was in a sound business, but it was in the logistics and oil field services industries, both of which got “hammered” as the oil price fell and economic growth dried up.

Even though 80 per cent of the fund’s capital was not invested, investors were paying full management fees. The manager “thought about cutting the management fee, but if you do that you reduce revenue to the firm at the wrong time,” Hunter says. “So they made a rare decision. Since they couldn’t invest the fund, they left it with the majority parent and two investments to exit, and returned the capital.” “It was honourable. They didn’t want to put good money after bad, and it helped limited partners with liquidity. Someone finally stood up and understood the reality of the situation.” The decision – the equivalent of harakiri in private equity circles – will undermine any attempts the manager might make to raise capital in the future.

But it was a rare show of respect to investors in an industry in which, the forfeiting manager told Hunter, “there are so many firms in our position that won’t admit it”. Hunter expects low returns from private equity investments in the next few years as managers use what capital they have to turn their companies into viable prospects for sale. “It is a slow-growth environment. We’re seeing managers fail, while some are wildly optimistic for the next year, but are struggling to get their investments off the ground. To get gains will take two to three years.”

The managers who will deliver the best returns should be those acquiring controlling stakes in distressed companies and implementing turnaround strategies, which essentially involve “getting the debt and taking control of the company through some restructuring company, rather than getting out like in a private equity strategy”. “2010 and 2011 might see a lacklustre economy. But if you build a position in a company, when debt goes down and it has to go through restructuring, later you might create a good company.” Preqin also sees a tough few years ahead for private equity managers: “With deal-flow down, fundraising down, leveraged finance not available at the same rate as in the past, and the market for exits also suffering, the state of the [industry] looks relatively bleak.”

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