Private Equity (PE) investing has grown dramatically over the past 5 years in an Indian Stock Exchange, and the private equity funds have produced excellent returns for investors. Private Equity funds have become very popular and trendy "alternative investments" that many large investors (high net worth families and institutional investors) have felt like that had to be involved with. Private Equity funds try to acquire companies or businesses cheaply. They use lots of tax-deductible debt to leverage their returns, cut costs to try to improve the short and long-term profitability, and sell assets to take capital out. Sometimes they pay themselves a dividend out of company-owned assets, and they eventually (2-5 years later) sell out to another buyer or take the company public at a higher valuation.

The favorable conditions that helped drive the recent private equity boom have changed dramatically over the past year. Future private equity returns will be much lower than they were over the past 5 years and could prove to be quite disappointing for many investors. I believe the private equity peak was 2006 and the first half of 2007. The Private Equity boom was driven by very cheap debt, a bull market in equities, a strong global economy, rising corporate profits, massive capital inflows into private equity, Sarbanes/Oxley reporting rules for public companies, and strong initial returns. Some of the large private equity companies are Blackstone, Carlyle Group, Kohlberg Kravis Roberts, Texas Pacific, Thomas H. Lee, Cerberus and Bain Capital.

Private Equity Historical Returns:

Past returns in the large private equity funds have been very good, beating equity market returns. According to Fortune Magazine over the 10 years to mid-2006 (the likely peak for PE) returns on private equity averaged 11.4% vs. 6.6% for the SP500 stock market index. Longer-term (20-year) results show that private equity investments have returned about a 4%-5% premium to the public equity markets. Of course, these superior returns are achieved with significantly higher risk and an investment that is "locked up" for many years.

Rudra Investment Equity Expert Concerns About Private Equity Investing and Future Returns:

Debt has become much more expensive for leveraged buyouts. The cheap and plentiful debt was one of the key factors that allowed private equity firms to succeed. Private equity is often just a leverage buyout (LBO's) of companies. Over the past 5 years, high yield or "junk" debt was very cheap and traded at a very small premium to Treasury debt. Over the past few month junk bond debt cost premiums have jumped significantly (from approximately 4 % to 10%), and the availability of high yield debt has decreased dramatically due to the credit crisis. Future PE returns will be hurt because of this higher cost debt, and because they will not be able to use as much leverage. Less leverage means lower returns for investors. The economy is much weaker now. We may be in a recession right now. Recessions are normally very bad for leveraged companies. Given how much debt these companies layer on to their investments these private equity investments carry a fairly high level of risk. Private equity firm Cerberus is struggling with its leveraged ownership of Chrysler and GMAC (housing and auto loans, 1Q08 loss of $589M) in the current economic downturn. There has been massive growth in the number of private equity firms and the dollars of capital invested in private equity, all chasing the same deals, and paying higher prices. Above average returns nearly always get competed away as tons of new supply or capital enters the market. Acquisitions are now much more competitive and expensive. Private equity companies can't buy companies "cheap" anymore with all the competitors bidding for the same assets. Many of the large hedge funds have also gotten into the private equity business over the past several years, making it an even more crowded space. More players chasing deals at lower returns just to "put money to work"? Several big private equity firms have recently gone public. Why would they do that? That is inconsistent and hypocritical with their whole philosophy of how much better it is to run companies privately. Did they sense a "top" in the market for private equity? I think so. The industry insider "smart money" was selling, so why should we be buying? The PE companies that did go public have seen their stocks drop significantly recently on concerns about the private equity industry. Blackstone (BX) is one of the biggest players in the private equity business. Their stock has fallen by over 40% since they went public (at the peak) and their fourth-quarter earnings (announced March 10th) were down by 89%. Some of the private equity firms are recently having trouble getting big deals done. Some big buyout deals have fallen apart due to the less attractive terms with the new environment, a slower economy, or the inability to get financing. Less big deals getting done and at less attractive terms means lower future returns for private equity investors. The Private Equity firms are going after smaller and less lucrative deals out of necessity. The firm is now doing little investments, making personal investments in public companies (PIPE's), help small growth companies, and buying translatable debt. These types of deals are likely to result in lower returns than the traditional big LBO deals of the past. Blackstone chief James says "we are looking at deals that don't depend on leverage". Harvard business professor Joshua Lerner says the term LBO is a bit obsolete when neither leverage nor a buyout is at hand. Many of the big PE firms are not able to find good investments so they currently are sitting on lots of cash, which doesn't produce much of a return at all. Fees are very high for investors. The private equity fees are typically 2% per year, plus 20% of any profits earned. That is very expensive, especially if they are investing in cash, converts, PIPE's, smaller less leveraged deals and expected returns are significantly lower than they were in the past. Access to the best funds and private equity companies is restricted. If you are a smaller investor with only a few million to invest in private equity, you are unlikely to get access to the biggest or best private equity companies and funds. Past performance of a particular PE manager may not be a very great indicator of future performance. You may have to settle for a less seasoned private equity fund or a "fund of funds" with an extra layer of fees.

I think there will still be a place for private equity investing among large institutional investors, but that returns could be somewhat disappointing over the next 2-3 years for everyone. In my opinion, most individual investors should avoid this investment sector for now.

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