Friday Letter Enough already: mega-fund bashing misses the point

As limited partners continue to debate the merits of large buyout funds, evidence grows that they may not turn out to be the poor performers some had assumed.  

Managers of private equity mega-funds would have been interested in a conversation going on within the walls of one of the world’s foremost limited partners this week.

At a board meeting for the $228 billion California Public Employees’ Retirement System, according to a transcript, one member said he couldn’t understand why CalPERS was continuing to do business with mega-funds. What followed was a discussion over performance and about just how the massive pension could otherwise deploy meaningful amounts of capital into different types of private equity funds and opportunities.

As one of the industry’s biggest backers, and a pacesetter for institutional investors, it matters what CalPERS thinks and does. If it said “bye” altogether to mega-funds, that could spark similar actions among other LPs. And without the sizeable cheques from US public pensions, raising $5 billion, $7 billion or even $10 billion buyout funds would become an altogether more difficult undertaking.

Existing mega-funds, however, have been charting a steady return to health, having been plunged firmly into the doldrums during the downturn. The Blackstone Group, for example, earlier this month revealed that its private equity holdings rose 29 percent in value in 2010. The same thing was happening across the pond, with Permira telling investors the value of its funds had increased 30 percent in 2010.

As the CalPERS transcript makes clear, investors remain concerned about exposure to large, highly levered deals struck pre-credit crisis, which many observers – and even a few industry insiders – have alleged time and again were doomed to fail. However, the Blackstone and Permira rebounds appear to tell a different story, as does a recent piece of research from Adalbjorn Stefansson, the head of buyout investments at Skandia Life, a Swedish insurer with €30 billion in assets under management and a target allocation of 10 percent to private equity.

Stefansson has examined the performance of more than 100 deals agreed between 2005 and 2007 with enterprise values of $2 billion or more. His findings, in a nutshell, suggest that far from being the sick children in the portfolio, these large buyouts were on average outperforming the public markets, even if one discounts the deals that were “sold well” before the collapse of Lehman Brothers in 2008. Deals struck between the beginning of 2007 and mid-way through 2008 were on average showing a gross return multiple of 2, he says, while the average gross return multiple for the following 18-month period was 1x.

Stefansson admits that more realisations will be needed before LPs will truly be convinced that the mega end of the market was – and remains – a prudent place for their capital in the long term. However, some recent news suggests that these realisations may soon be starting.

Earlier this month Kinder Morgan, the subject of a $27.5 billion leveraged buyout in May 2006, raised $2.86 billion in the largest-ever private equity- backed initial public offering in the US and the largest energy IPO since 1998. Its private equity backers – Goldman Sachs, Highstar Capital, The Carlyle Group and Riverstone Holdings – sold a 13 percent stake in the offering. Some estimates have put the corresponding return multiple at nearly 3x for the sponsors, whose remaining stake is valued at a reported $26 billion.

The Kinder Morgan coup surpassed the equally cheer-inducing offering in January of TV ratings and research company Nielsen Holdings. That IPO priced at $23 and quickly jumped to more than $25 per share, providing a boost to the private equity consortium that in 2006 took Nielsen private in a $10 billion LBO.

Meanwhile, hospital operator HCA, which has already paid out a reported $4 billion in dividends to sponsors, has filed plans for a $4.6 billion IPO that is expected to price in March. Purchased in 2006 by KKR and Bain Capital in a $32.7 billion buyout, its progress will be watched closely as will that of many others: at least 21 private equity-backed IPOs worth a combined $9.7 billion are in the pipeline, according to data provider Dealogic.

Should the string of successful listings continue, it may help provide further validation the mega-boom may not have been a mega-bust after all. That, of course, would mean LPs could be eagerly saying hello, not goodbye, to the mega-funds once again.