The great private equity shakeout

Every economic slump has toppled some of private equity's top bananas and sent loads of lesser firms to oblivion. In the early 2000s, huge soured bets on telecom and high tech doomed Forstmann Little & Co. and Hicks Muse Tate & Furst, both formidable players.

The Great Recession, many foresee, will produce more casualties than past downturns. "There will be a real shakeout," says one banker who works with major private equity firms. "A big question is, who will be the Forstmanns and the Hicks Muses of this cycle?"

However it plays out, the shakeout will be only the most visible element of a sweeping rationalization that will dial back the size of an industry that had soared until the financial crisis. Not only will as many as 20% to 40% of all buyout firms close down, experts say, but most survivors will experience a dramatic rollback in funding from investors. The industry may well shrink to its pre-2004 dimensions.

Indeed, a big difference in this down cycle is expected to be the sizes of the investment funds raised by the big brand-name firms. The previous downturn didn't even create a hiccup in the financial arms race: Even as Forstmann and Hicks Muse flamed out, their surviving peers, firms like Blackstone Group LP, Thomas H. Lee Partners LP, DLJ Merchant Banking Partners and Warburg Pincus drew record commitments of $5.3 billion to $6.5 billion. In this cycle, Blackstone has struggled to pull in $13.5 billion for its latest fund. Though the sum is hefty and is the most any firm has raised since 2008, it is markedly smaller than Blackstone's 2006 fund, which topped out at $21.7 billion, and falls below the $15 billion target Blackstone reportedly has set.

Blackstone managed to bag most of the $13.5 billion before the bottom fell out of the market. A more telling bellwether of what looms will be how Kohlberg Kravis Roberts & Co., another marquee name with a superior track record, fares when it sets out to raise its latest fund in the coming months. KKR hopes for a better outcome than it got in 2009 when its first stab at marketing the new fund failed. It has set its sights low, targeting the fund at only half the size of the $17.6 billion fund it had garnered in 2006. Even that proved tough to raise, so KKR decided to wait until conditions improved.

Yet KKR and others peddling new funds shouldn't get their hopes up. Even though buyout activity itself has perked up, the hard truth is that many LPs have no choice but to slash future PE commitments. Having pledged a total of $840 billion into buyout funds from 2005 to 2008, according to Preqin Ltd., only to see their investment portfolios tumble in value when the markets tanked, many large institutional investors are overallocated to the buyout category and must cut back to rebalance accounts.

Observes one KKR investor: "KKR has a fine record, and I believe in their strategy and their team. But even if I wanted to, there's no way I could commit as much money to their next fund as I did to the last."

In addition to downsizing private equity's purse, the next fundraising cycle could shift the industry's center of gravity. Convinced that big buyout houses sank too much money at the peak of the market into overleveraged, overvalued megadeals that look to be losers, many LPs say they're disenchanted with big-cap buyouts and are thinking smaller.

"A lot of LPs have been burnt by the megabuyouts in this cycle, and so they're looking to get into the middle market," observes Barry Gonder, a partner at pension fund consultant Grove Street Advisors. Says a fund-of-private-equity-funds manager: "If you look at 2006 to 2008, large-cap funds account for about 49% of the private equity capital raised. We're now recommending that our clients put only 10% to 15% of what they commit into large-cap funds.

"We just think large-cap will be a less interesting space for the next couple of years," he says, explaining that the midsized market should benefit from abundant dealflow and more favorable supply-demand dynamics.

Clearly, though, the biggest change in private equity will be a thinning of the ranks. Scores of weaker performers will be drummed out of the business, pension managers and other LPs say.

Watch List
A sampling of PE firms with middling recent records
	Year fund closed	Size ($M)	Percent invested	Realized and unrealzed value / investment cost	Internal rate of return*
IMPERILED: Sponsors least likely to survive
J.C. Flowers & Co. LLC	2006	$7,000	100%	0.36	-39.7%
Candover Partners Ltd.	2005	4,100	82	0.50	-26.4
Terra Firma Capital Partners	2007	7,300	64	0.27	-47.7
Elevation Partners	2004	1,900	80	0.82	-9.9
PRESSURED: Sponsors in limbo
Madison Dearborn Partners LLC	2006	6,500	82	0.80	-7.4
Fenway Partners	2006	702	100	0.91	-5.6
MatlinPatterson Global Advisers LLC	2007	5,000	76	0.95	-3.5
ZOMBIES: Sponsors that have flat-lined
Cypress Group	1999	2,500	100	0.82	-5.1
Heritage Partners	1999	840	94	0.48	-24.5
Stonington Partners	1994	1,000	93	NA	-0.8
* IRR: Net annnual compound internal rate of return as of March 31 NA = Not Available Source: Public pension funds data, Preqin Ltd., The Deal

"We expect that investors are going to pare back weaker performers and concentrate their private equity portfolios with fewer, best-performing managers," says Marc Sacks, head of private equity investing at Mesirow Financial Inc., a fund-of-funds manager. He and others note that, after factoring out the impact of leverage on investment returns and factoring in fees, most sponsors underperform the stock market. Mediocrity, he says, doesn't cut it.

"If you invest with too many private equity managers, you end up with returns that regress to the mean, or worse. That's not acceptable." Accordingly, he and others say, LPs will purge their portfolios of stragglers.

Which returns us to the question of whether any of the industry's very biggest stars will fall. The answer, LPs say, is probably not -- at least not any firms as mighty as Forstmann or Hicks Muse were in their prime.

That may come as a shock to those who recall how wretchedly the $10 billion fund that one top-tier player, Apollo Management LP, raised in 2006 was performing less than a year ago. Apollo's sixth flagship fund sank $1 billion into a disastrous purchase of real estate broker Realogy Corp., and it backed a now-distressed buyout of casino operator Harrah's Entertainment Inc. At the end of 2009, the fund was valued at just 60% of what it had invested, sources say. But Apollo presciently bought up debt on the cheap in companies it owns, and that debt has rallied, boosting the fund's mark-to-market value as of March 31 to 120% of cost. By the lackluster standards of vintage 2006 funds, that's a stellar performance.

Cerberus Capital Management LP is another big name that splurged on failed buyouts, most notably those of Chrysler LLC and GMAC LLC, but has mounted a comeback. Owing to well-timed bets on distressed mortgages and the hugely profitable sale of its stake in Talecris Biotherapeutics Holdings Corp., its latest flagship fund shows a slim profit. A third well-known firm, Fortress Investment Group LLC, hasn't fared nearly as well. Some of its largest private equity investments are struggling, and the $2.5 billion fund it raised in 2006 was valued on March 31 at 79% of cost.

Fortress, though, has something going for it that many buyout firms don't: diversification. It oversees a passel of hedge, credit and PE vehicles totaling $31 billion in managed assets. When one operation falters, the others afford cover. Because of that, Fortress isn't in imminent danger.

Still, some second-tier firms are clearly in peril.

J.C. Flowers & Co. LLC: Of second-line U.S. players, J. Christopher Flowers' New York buyout shop is at the top of the endangered list. The former Goldman, Sachs & Co. M&A hotshot displayed his Midas touch in 2000, engineering a $1.1 billion bailout of Japan's Shinsei Bank Ltd. (formerly Long-Term Credit Bank). That deal delivered a fivefold profit. But many of Flowers' subsequent bets have foundered -- including a large follow-on investment in Shinsei.

Flowers, whose favorite niche is financial services, took heavy losses on hefty investments in Germany's Hypo Real Estate Holding AG and in German shipping lender HSH Nord-
bank AG. His successes, including a deal to sell Fox-Pitt Kelton for a 100% gain, have been few and relatively small. Last year Flowers drew the ire of his peers with a boast he made about a deal he helped orchestrate to buy IndyMac Federal Bank, the failed California lender, from the government: "The government has all the downside and we have all the upside." The remark is widely believed to have induced the U.S. government to restrict sales of failed banks to PE groups.

Nor are his LPs any happier with him. As of March 31, the $7 billion fund that J.C. Flowers completed raising in early 2007 was valued at just 38% of cost.

"At the last investor meeting, the LPs were up in arms," says one LP. "Unless that performance improves dramatically, he won't be able to raise another fund."

Terra Firma Capital Partners Ltd. and Candover Partners Ltd.: These prominent British firms appear to be even worse off than J.C. Flowers.

Guy Hands, Terra Firma's founder, got into the same bind as Forstmann Little did by risking a large part of his purse on one disastrous deal. (To be fair to Forstmann, it diversified a bit more, blowing much of its capital on two disastrous deals.)

Terra Firma sank just under a third of the €5.4 billion ($7.3 billion) fund it had raised in 2006 into a £4.2 billion ($6.6 billion) leveraged buyout of U.K. music giant EMI Group Ltd. in 2007. That deal was valued at an eye-popping 18 times cash flow, and EMI's sales nose-dived soon after the deal closed.

EMI has dragged down the overall value of the 2006 fund -- it was just 27% of cost as of March 31. Says one Terra Firma investor: "If they were to come to market today with a fund, they couldn't raise it."

Candover, an old-line firm founded in 1980, also is on the ropes. In August, Candover Investments plc, the firm's publicly traded British affiliate and a major investor in Candover's deals, went into runoff mode. One source insists the decision to go into runoff applied only to the affiliate and could open the way for Candover Partners to raise a new fund. But with Candover's €3.5 billion 2005 fund valued at 50% of cost on March 31, its odds of doing so aren't terrific.

Elevation Partners: Specializing in media and tech, Elevation started life with a bang in 2004, raising $1.9 billion for its inaugural fund. Its chances of raising a second fund at this point aren't encouraging.

LPs say the strikes against Elevation are its so-so performance -- not awful, but nonetheless subpar -- along with the firm's brief history and its move to recruit the ubiquitous rock star Bono of U2 as a managing director. Some LPs consider Bono a vanity hire by Elevation co-founder Roger McNamee, a big rock 'n' roll fan.

As of March 31, Elevation's investments were worth just 82% of cost. Its odds of survival have not been helped by its microscopic profit on selling Palm Inc., the smartphone maker, an investment that ate up nearly 25% of its fund. An early investment in video games designer VG Holdings Corp. was a winner, but a minority investment in magazine publisher Forbes Media LLC has been a loser, a source says.

Even if its returns turn positive, Elevation could be stigmatized in LPs' eyes by its slender track record. "It's a first-time fund -- they don't have any prior funds" to point to, says one fund-of-funds investor.

This investor notes the firm could get a fresh lease on life if its stakes in Yelp Inc., a user-generated review website, and Facebook Inc., the immensely popular social networking platform, do well. Even if they do, though, he doubts Elevation could raise another large fund, since it failed to deploy the entire $1.9 billion during the allotted six-year investment period.

More numerous are sponsors with middling recent records that LPs say could be chopped down in size:

In 2009, Madison Dearborn Partners LLC's existence appeared to be hanging by a thread. The biggest private equity boutique in Chicago, it raised a $6.5 billion fund in 2006 and proceeded to plow much of it into king-sized buyouts of systems integrator CDW Corp., fund manager Nuveen Investments Inc. and Spanish-language broadcaster Univision Communications Inc., all of which went on the fritz. The fund was deeply underwater.

Since then, however, the fund's value marks have risen considerably, though not as strongly as Apollo's and Cerberus'. "Nuveen's performance has come back nicely, and so has CDW," says an LP. As of March 31, the 2006 fund was valued at 80% of cost. Struggling Univision remains a major question mark.

Madison Dearborn won't need to drum up money for a time, having closed a $4.1 billion fund earlier this year. Though that's a lot, the sum suggests the firm has been knocked from its perch as one of private equity's leading players.

Middle-market mainstays Fenway Partners and Veronis Suhler Stevenson may also face an uphill battle attracting anything close to the amount of funding they did in the past. Their weakness is their averageness -- their failure to stand out at a time when LPs are concentrating commitments with superior performers. Remarks one Fenway LP: "Suffice it to say that if the returns on Fenway's last two funds don't improve, it will be difficult for them to raise another fund."

Distressed securities investor MatlinPatterson Global Advisers LLC could find itself in the same boat. Its latest fund's performance suffers by comparison with Centerbridge Partners LP and WL Ross & Co. LLC, two rival vulture investors that have "just knocked the lights out," one LP says.

Finally, there is a small host of once-prominent firms that tanked years before the economy did. Unable to raise new funds, they've been forced into runoff mode: Brera Capital Partners LLC, Cypress Group, Heritage Partners Inc., Questor Management Co. LLC, Stonington Partners Inc.

Needless to say, the next fundraising cycle will move some firms to the top of a reshuffled deck. Already, two new industry powerhouses have emerged, San Francisco's Hellman & Friedman LLC, which boasts a top-decile record and which locked up an $8.8 billion fund last year, its largest ever, and First Reserve Corp. an energy-focused sponsor that last year corralled $9 billion.

Just as past periods of turbulence in private equity have produced turnover in the ranks, the industry's current travails will spawn a handful of new front-line players even as others are sent packing.