An embarrassment of riches

When limited partners were making commitments of $500 million, $1 billion, even $1.5 billion to supersized private equity funds, they were signing up to an investment environment that ended up changing dramatically.

Today the private equity opportunity looks very different than it did in 2006 and 2007 and yet the record commitments made during the “golden era” are still, for the most part, with us – and much of the money has not yet been invested.

According to a State Street Private Equity Index estimate, there is currently some $490 billion in undrawn private equity commitments – “dry powder” – waiting to be fired out at target investments. The so-called “overhang” of capital is the result of investments not having kept pace with fundraising.

Indeed one distinct feature of the current economic downturn is that the turmoil has not led to much deal flow (unless the buyer in question is the US Treasury Department). As Fortress Investment Group co-founder Wes Edens put it during a speech at Columbia University last month, many companies that would have otherwise been forced to sell assets have been able to ride out their balance sheet problems. “The great liquidation turned into the great refinancing,” said Edens. “There have not been tremendous dislocations that have created huge amounts of assets.”

An optimist would look at the nearly $500 billion in overhang and say that it means GPs have an unprecedented amount of capital to begin snapping up assets on the cheap once the market thaws. The returns made from this feeding frenzy could balance out the bitter disappointments of the past few years, which could in turn assure private equity a permanent and even growing position in institutional portfolios for the next decade.

But there are pessimistic counterviews to this sunny scenario. One is that GPs simply will not see $500 billion in quality opportunities before their investment periods run out. And while some GPs have successfully returned capital, in general they tend to be more motivated to put capital to work. This could lead, and perhaps already has led, to style drift. Some are already worried that the few quality companies for sale are generating the kinds of heated auctions that don’t tend to produce attractive pricing for the buyer.

In fact, the more macro-minded pessimists worry that the private equity overhang will contribute to a coming inflationary wave.

Then there is the issue of actually accessing the money, which currently resides in the coffers of thousands of LPs – many of whom will still be facing pressure on their cash flows – around the world. While fears of the LP defaults have faded somewhat from the beginning of last year, it is unclear whether all the counted-on dry powder is actually ready for delivery.