Christopher Zook remembers the Alamo. He was having dinner there in 2014, when the concerns of U.S. pension funds emerged in conversation. There is no restaurant on the hallowed ground where Texans fought for their independence in the 1830s, but a private equity firm was hosting a catered event for investors, recalls Zook, the founder of CAZ Investments, a Houston-based multifamily office that oversees $1 billion in assets.

As the wine poured, pension managers discussed the challenges they faced allocating to private equity, he says. They had received large distributions from the industry as the funds in which they had invested exited their deals at a profit, and now had larger portions of their pension portfolios dedicated to the asset class. It was overwhelming.

“They got paid back all at once,” says Zook. “They got money back faster than they could spend it.”

With billions of dollars to put to work, they were committing hundreds of millions to each private equity manager, fueling ever-larger funds across strategies such as buyout, growth, and venture capital. Cutting huge checks was preferable to the daunting task of selecting, say, 200 funds in which to invest $50 million each. The pension fund managers figured that as long as they were contributing to big, successful buyout funds, they would keep their jobs if boom times suddenly went bust, recounts Zook.

And why not? After all, private equity has performed well, with the industry’s double-digit returns standing out in an era of low interest rates begun after the 2008 financial crisis. But the record fundraising that naturally followed has pushed the industry’s dry powder to more than $1 trillion — the most ever — while buyout valuations have risen to worrying levels amid the increased competition for deals.

“It is scary out there,” says David Fann, president and CEO of TorreyCove Capital Partners, a San Diego-based firm that advises institutional investors on private equity, private credit, and real assets. “There is a lot of risk. It’s a strange environment for sure.”

While private equity remains popular with investors, there’s reason to be cautious as the economy stretches into its ninth year of expansion. Fann says he recently heard from an investment banker in the Midwest that “crappy little companies” are being sold for 12 times cash flow, when they should be valued at seven times. The debt used to finance these deals could spell trouble down the road.

“Rising interest rates could potentially be a problem,” says Fann. Higher interest payments can eat into cash flow over time, leading to a large drop in a company’s valuation. He explains that a company needn’t be faltering for its buyout by a private equity firm to turn into a money-losing deal for investors. “Unless you improve those companies’ operations dramatically, you could be looking at a significant loss,” he says.

Yet these concerns haven’t stopped private equity firms from racing to investors for more capital — indeed, the very recognition that bull markets don’t last forever may be fueling a rush to raise money.

The demand is global. UBS’s private funds group, which helps managers attract capital from institutional investors, is seeing more money flow into the industry from Asia.

“We continue to be extremely busy,” says Kevin Kuryla, global head of the Swiss bank's private funds group. “One of the lessons coming out of 2008 was to have true diversification in your investor base, not only by limited partner type, but also by geography.” He estimates about two thirds of the capital pouring into private equity a decade ago was from North America, with the balance largely stemming from Europe and the Middle East. Now, Kuryla sees a much more even split between North America and the rest of the world.

“We’ve seen much more significant capital coming out of Korea and China,” he says. Japan has also become more active, he adds, while Australia’s superannuation funds have remained steady investors in private equity.

TorreyCove’s Fann points to a rise in sovereign wealth funds moving into the industry, including Japan’s Government Pension Investment Fund and Japan Post Bank. “And then there are more Middle Eastern pools of capital,” he says. “The Saudis have become more aggressive in investing in private equity.”

Private equity firms are also raising more capital from the wealth management industry, where financial advisers are introducing their affluent clients to feeder funds that pool assets of high-net-worth individuals to invest in funds run by firms such as Blackstone Group and KKR & Co., according to Fann.

“It’s a very, very crowded fundraising environment right now,” says Kuryla. “A number of funds are coming back sooner because they want to hit the market — before the perceived window closes.”

The private equity capital-raising bonanza has at least one clear implication: inflated prices.

Buyout multiples last year climbed to a record 10.2 times earnings before interest, taxes, depreciation, and amortization, according to S&P Global Market Intelligence. This year they remained elevated at an average of 9.5 times ebitda through May, a level surpassing the 2007 peak of the precrisis buyout boom.

The trend has the attention of the investors in their funds.

“Limited partners are concerned, but they are still investing in the asset classes,” says Kuryla. “They recognize market timing is difficult and they’re better off having consistent investment over time.”

CAZ, which made a huge profit shorting subprime mortgages with John Paulson before the housing bubble burst in 2008, is generally steering toward middle-market private equity firms, according to Zook, who sees them relying less on leverage to produce bigger returns. CAZ will consider investing in big buyout funds, but Zook says there’s a way to share in their success without paying a premium in fees: buying pieces of the asset managers themselves.

He seeks exposure to large firms such as Vista Equity Partners by investing in funds managed by Dyal Capital Partners, a unit of Neuberger Berman that buys minority stakes in alternative asset managers. Where CAZ is a minority owner in private equity firms, the multifamily office shares in the management fees and so-called carried interest, or their cut in profit from successful deal-making.

Vista, a private equity firm focused on technology investments, is now raising its largest buyout fund ever, targeting $12 billion, according to Preqin, a provider of alternative-assets data. If successful, Vista’s Fund VII will be twice the size of the $5.8 billion Fund V that the firm closed in 2014. A spokesman for Vista declined to comment.

The bigger the fund, the more that may be collected in management fees.

“The pricing in this industry was created when funds were $100 million,” says Thomas Roberts, founder and CEO of newly formed private equity firm Equality Asset Management. “Now, for a lot of firms, they’re between $10 billion and $20 billion in assets, and the pricing has changed only a little.”

Roberts, who worked at private equity firm Summit Partners for 28 years, expects Equality will begin seeking capital from investors after Labor Day. The Boston-based firm, which focuses on health care and technology deals, will offer a new type of fee structure, he says.

To stay competitive, Roberts believes private equity firms will need to lower their fees, build more concentrated portfolios with high-conviction bets, and hold their investments longer. He expects to remain invested in deals for eight to 12 years, instead of the typical three- to five-year period — but declined to elaborate on Equality’s fee structure before it begins raising its first fund.

William Riddle, managing director and head of Lazard’s private capital advisory business, says his group is working with first-time fund managers who have left large, global private equity firms to run their own show. Some of these managers prefer working on smaller deals because they believe they can add more value by leveraging their experience from larger firms to help build businesses in the middle market, he says.

“Some feel like there’s more opportunity to generate strong returns in the smaller end of the market,” he adds, saying the firms Lazard advises are increasingly in the $500 million to $2 billion range for assets, though some are in excess of $5 billion.

Institutional investors are generally seeking net returns in the mid- to high teens from private equity, according to Riddle. And they’re putting more capital to work with fewer managers, narrowing the number of relationships to focus on the firms that have delivered the best performance, he says.

In other words, they’re being more judicious as the bull market ages, anticipating a shakeout in the buyout industry.

“The view is that they’re going to continue to generate higher returns than what they can get in the public markets — or at least they’re going to outperform the rest of the industry,” says Riddle.

Yet despite concerns about a frothy market, past returns have kept investor appetite for private equity healthy — so healthy, in fact, that investors have been forced to get creative about their exposure.

Private equity funds returned 17.3 percent in the 12 months through June 2017, according to Preqin. That compares with 13.4 percent annual gains over the three years and 15.4 percent for the five years through last June.

As Zook points out, this success has benefited investors while at the same time creating the challenge of putting the vast distributions they received back to work.

Private equity firms have returned almost $2 trillion since 2013, with distributions exceeding capital calls for deal-making for at least six straight years, according to a June report from Preqin. The trend became pronounced in 2014, as investors sought to reinvest the gains to maintain their allocations or satisfy their increased exposure to the asset class.

For U.S. pension funds — which have been struggling for years to shore up funding for retirement benefits promised to workers — the appeal of private equity is clear.

Tom Tull, chief investment officer of the Employees Retirement System of Texas, says private equity was the best-performing asset class for the $29 billion state pension fund during the 12 months through May. And the distributions keep coming, he says, with some individual buyout deals delivering internal rates of return of more than 25 percent.

“The firms that we are working with are very competitive,” he says. “They’re the cream of the crop as far as we’re concerned.”

Texas ERS plans to increase its allocation to private equity over the next four years to 13 percent from 10 percent, he says. The pension fund is already at that level due to positive market performance that has boosted the net asset value of its allocation to $3.8 billion, including co-investments.



Private equity delivered Texas ERS a 17.34 percent gain during fiscal 2017, and a compound rate of return of 14.85 percent over the five years through August, according to Tull.



“The way markets have run, we are very fortunate that we are already at our objective for private equity,” he says. “We’re looking at more secondary opportunities whereby we can sell off parts of the portfolio.”



That means the pension is willing to unload some of its limited partner interest in funds managed by private equity firms, potentially benefiting from the premium that buyers may pay for exposure to them. Among its stakes in buyout funds is a $75 million commitment made to Carlyle Global Financial Services Partners III in the past year, according to a recent market summary on its website.



“The stock market is at very high levels,” says Tull. “We’ve been fortunate in doing a lot of good deals in the private equity space with our managers, so if we can be fortunate enough to sell some of our positions into the secondary market, we will.”



The Texas retirement plan sold about $1 billion of its private equity portfolio several years ago when the fund hit its threshold allocation, he says, profiting as the sales of its limited partner stakes fetched more than 8 percent over their net asset value. “The timing was right,” he says.



The pension is now seeking to work with managers willing to give the fund more co-investment opportunities, as well as those that provide more geographic diversification, according to Tull. “We like Asia; we like some of the emerging markets,” he says, adding that in expanding its international exposure, to get a better deal on fees the pension would consider managers who aren’t running “monster funds.”



Private equity firms might offer a discount in fees to early and large investors in a new fund, or they might give them the opportunity to sidestep fees in a co-investment pool offered as a sidecar to the main fund being raised, according to TorreyCove’s Fann.



The industry generally charges fees of 1.5 percent to 2 percent to manage assets and 20 percent for performance, he says. On the performance side, firms collect carried interest, or the cut of profits made from gains on their investments.



That’s too high for Tull. He says Texas ERS pays management fees averaging about 1.1 percent, while its cost on carried interest is about 12.4 percent. “There are some funds out there that are willing to pay 2-and-20,” he says. “We’re not.”



The biggest pension fund in the U.S., the California Public Employees’ Retirement System, is exploring another private equity avenue that would avoid fees: It’s reviewing a plan to begin doing its own deals next year. Allocations to the new program would be in addition to its current private equity portfolio, valued at about $27 billion at the end of April.



The pension announced CalPERS Direct in May, saying it expects to invest as much as $13 billion in private equity annually to achieve a 10 percent allocation. From a performance perspective, it’s easy to see the draw, as private equity has been CalPERS’ highest-returning asset class for the past 20 years, with a 10.6 percent annualized gain.



“It's critical to our success,” CalPERS chief executive officer Marcie Frost said in a statement last month. “But with a $355 billion portfolio, investing in funds within the private equity market isn't enough.”



The pension, which has 71 percent of the assets it needs to pay promised retirement benefits, is targeting a 7 percent return over the long term. To get there, CalPERS needs a “forward-looking private equity program” that will help it meet its return target, she said.

If such popularity gives you pause with private equity, you’re not alone.

Global fundraising totaled an unprecedented $453 billion in 2017, topping the previous record, set in 2007, of $414 billion, according to Preqin. Managers this year, meanwhile, are competing for investors’ money in record fashion.

An unprecedented 2,974 private equity funds last month were seeking a record $945 billion of capital, the data provider said in a report. The intense competition has continued even after the industry’s dry powder — or the uninvested capital committed by investors — rose to a new high of $1.09 trillion in March.

As global investors keep turning to private equity for returns, the heightened competition for deals, and the use of debt to finance them, may bite into — or seriously jeopardize — the gains they’re hoping to reap from the buyout industry.

S&P Global Market Intelligence estimates that buyout debt levels averaged about 5.7 times ebitda in May. That’s up from as low as 3.7 times for deals done in 2009 and not far from a peak of 6.05 times in 2007 — the height of the buyout boom that preceded the financial crisis. The deep recession that followed left many highly leveraged companies in distress as their earnings plummeted.

Seeing the dangers of a ballooning loan market as the economic recovery took hold, bank regulators soon moved to curb excessive risk-taking. The leveraged lending guidelines issued in 2013 by the Federal Reserve, the Federal Deposit Insurance Corp., and the Office of the Comptroller of the Currency said a debt level exceeding six times a company’s ebitda raises concerns.

Now regulatory pressure on risky lending appears to be easing.

In late February, Joseph Otting — the head of the OCC appointed last year by President Donald Trump — said at a conference in Las Vegas that banks no longer needed to adhere to the leveraged lending guidance, according to a client alert from law firm Ropes & Gray.

“Lending to leveraged borrowers must be conducted in a safe and sound manner,” a spokeswoman for the OCC said in an emailed statement. “The guidance remains guidance and does not establish bright lines that represent limits or conditions, nor was it ever intended to do that.”

Mixed in with investors’ concerns over increasing interest rates and high buyout valuations are rising geopolitical tensions, according to Fann. He says investors worry about the impact U.S. trade wars with Canada, China, and Mexico could have on private equity firms’ portfolios.

For a glimpse of the consequences that could ripple across portfolios of companies owned by private equity firms, consider the position of American icon Harley-Davidson.

Trump’s trade battle with Europe prompted the company to disclose last month that it was moving some of its production outside the U.S. to avoid European tariffs imposed on its motorcycles in retaliation for U.S. duties on steel and aluminum. The motorcycle maker said in a regulatory filing that Europe is its second-biggest source of revenue after the U.S., and that passing costs on to customers would be detrimental to its business.

Still, Fann says investors’ concerns about private equity may be viewed as largely an “emotional feeling,” as the U.S. economy is growing with strong corporate earnings and low unemployment. Backing this sentiment, Josh Feinman, chief global economist at DWS, formerly known as Deutsche Asset Management, wrote in a June 19 note that “the economic expansion, already the second longest on record, is showing little sign of wear, underpinned by sound domestic fundamentals, fiscal stimulus, and the lagged effects of easier financial conditions.”

But investors know that markets can change suddenly.

That’s why Zook, chief investment officer at CAZ, is avoiding highly levered deals he’s seen valued at ten times ebitda. “We probably wouldn’t even touch them at eight times,” he says. In his view, the risk just isn’t worth it.

“It’s absurd,” he says.