Harry Campbell

It is not easy being a private equity firm like the Blackstone Group or Kohlberg Kravis Roberts these days. Not only do you have to worry about being dragged through the mud in a presidential election, but the business isn’t the money machine it used to be.

In the years leading up to the financial crisis, private equity dominated the takeover market, taking advantage of cheap credit and investors begging to participate. In the first half of 2007, according to Dealogic, the industry accounted for more than 18 percent of announced takeover volume in the world. It all came crashing down, and last year private equity accounted for a bit less than 7 percent of total global takeover volume, according to Dealogic.

If private equity’s recovery from the financial crisis has been fitful, its future looks uncertain.

One of the industry’s biggest problems is that it has too much money to invest. According to Preqin, private equity firms had at the end of last year about $900 billion worth of “dry powder,” or money that they raised mostly before the financial crisis and still needed to invest. At current takeover rates, this would take almost a decade.

So one might think that the path to private equity’s future is more deals. Yet the deals currently on offer are expensive. Bain & Company, Mitt Romney’s former employer, recently reported that multiples for private equity deals in the first half of 2011 were roughly 8.5 times Ebitda, or earnings before interest, taxes, depreciation and amortization, a common metric for pricing companies. This compared with multiples of 6 to 7 times Ebidta at the end of the last recession.

Not only are deals expensive, there are fewer sellers than usual because they do not want to sell in a market that they think is underpriced. Private equity firms also face increased competition from strategic buyers, who are flush with cash. Moody’s Investors Service reports that nonfinancial companies rated by the firm held $1.24 trillion in cash at year end 2011.

These developments mean that private equity risks overpaying when it puts its capital to use. A recent bidding contest between Apollo Global Management and KSL Capital Partners over Great Wolf Resorts, an indoor water park operator that had lost money every year for the past five years, is illustrative of the lengths private equity firms are going to secure companies.

To top this off, the credit market remains in a perpetually choppy state. Some deals, like the acquisition of Del Monte Foods, which was completed in March 2011, came with spectacularly low interest rates, but lately the market has been more expensive for leveraged buyouts.

Private equity firms are also having trouble selling. It is estimated that they have more than 5,000 companies in their portfolios waiting to be sold, companies worth almost $2 trillion, according to Bain. The value of the companies waiting to be sold by private equity is greater than the money private equity has to invest.

And the traditional route for exits, the market for initial public offerings, is not particularly hospitable these days. The bad taste from the Facebook I.P.O. may further diminish investors’ appetite for new stocks.

This leaves sales to private buyers, like other private equity firms. About a quarter of private equity exits are pass-the-baby sales, according to Preqin, in which one private equity firm sells a company to another, but that only defers the problem.

As if private equity did not have enough challenges, returns are down and fund-raising has slowed. Returns to private equity are difficult to find and analyze, but it appears that many funds from before the financial crisis are flat to modestly up and certainly not returning the 20 percent to 30 percent that they have sometimes yielded in the past. In 2011, private equity investors got back more money for the first time in four years than they were required to invest, according to Bain.

So what does this all mean for private equity?

The lack of credit has killed off the gigantic buyouts that occurred before the financial crisis and pushed big players like Apollo and K.K.R. into the middle market for deals.

They, in turn, are pushing out many of the medium and small players. The Boston Consulting Group’s prediction in 2008 that 20 percent to 40 percent of the larger buyout funds would go out of business may well come true.

Foreign markets are thought to be a savior, but I am skeptical. The European private equity market has ground to a halt with credit in short supply and sellers refusing to negotiate. Private equity firms have promoted China, India and Brazil as top investing markets. David Rubenstein of the Carlyle Group has been a tremendous proponent of China, stating in 2010, “We cannot put enough money in China.”

Yet, both India and China have slowing economies. Investing in these countries requires local partners, and consistent profits may be difficult. And if profits are big, there may be a problem exiting, as Lone Star Funds, an American private equity group, found out when the South Korean government blocked its repeated efforts to sell the Korea Exchange Bank, amid claims that it was a vulture investor that violated local law by profiting too much.

With private equity becoming a smaller business, the largest firms are turning into global alternative asset managers. Blackstone now derives more revenue from nonprivate equity businesses. Apollo and K.K.R. recently cut a deal with the State of Texas to manage its alternative asset investments, including debt and private equity.

And another model may become more popular — shareholder activist investing. William A. Ackman of Pershing Square Capital Management and others have shown that taking big stakes in public companies and advocating for change can pay off with less capital spent.

This is not to say that private equity deals are not being done, just that the industry is prime for a shakeout. Private equity firms still appear to be earning outsize returns — or returns higher than those earned from stock investing. Investors, particularly pension funds desperate for higher yield, will still come, just in smaller numbers.

Nor will it mean that once the shakeout is over, companies can feel safe from the barbarians at the gate. If anything, private equity firms may become more aggressive in pursuing targets. It just may be that the gigantic killings in the years before the financial crisis will become a fading memory as private equity becomes more of a game of billions and not tens of billions of dollars.

For the future barons of private equity, this means a world where they have less impact. Deals will be smaller, and their hedge fund brethren will reap the bigger publicity and fees. Even so, private equity will remain an interesting and transformative business, and yes, a profitable one.