A dim view

The sense of doom and gloom at a recent institutional investors conference in New York was perhaps not surprising given the performance of many LPs portfolios over the last year.

Unlike the full-blown shock experienced by LPs during 2009, the negativity at the Argyle Investment Forum for Endowments, Foundations and Pension Funds was more of a resignation to the fact that the returns of the glory days of private equity were artificially high and would never get back to those levels again.

“A lot of private equity funds today are bigger. Will returns be as big as they were in the past? I find that hard to believe,” said an investment manager with the US Federal Reserve System at the event.

One major point of concern expressed repeatedly during the forum was the capital overhang in the private equity market, the pool of unspent private equity capital – estimated around $420 billion – awaiting deployment.

Private equity managers have raised about $1.1 trillion since 2005 and will have a tough time spending the money in a market that is estimated to be $90 billion to $100 billion, according to David Turner, head of private equity at Guardian Life Insurance Company of America.

Turner presented to delegates about the state of the private equity market, reflecting on some of the negative sentiment floating around the room. He dispelled the notion that great returns can be found in the lower to mid-market, arguing its dynamics had changed and valuations driven up in light of mega-funds having moved down-market for deals.

Managers at the lower end of the market “are at war right now”, fighting over the attractive deals, forcing auctions and increasing prices, he said.

Furthermore, Turner said there were “half a dozen or so” managers he wants to commit money to, none of which have come to the market. In order to meet the organisation’s target allocation to the asset class, Turner reflected he would have to choose the “next best option”, which would drive down returns.

Another institutional investor at the forum, a chief investment officer of a foundation, lamented commitments the organisation made during the peak years of the credit bubble: commitments the CIO felt would ultimately underperform. He questioned whether the asset class was really so desirable and had even harsher things to say about venture capital.

Disquiet among investors is not consigned to the rhetoric of the conference circuit. Developments at two firms over the summer illustrate how serious LPs are about getting the most they can from the asset class. Elevation Partners – the media-focused firm led by rock star Bono – was recently denied a fund extension by LPs (see p. 28), while energy-focused firm ArcLight is finding fundraising tough going, with LPs demanding more distributions before committing capital to the new fund.

ArcLight raised about $2.1 billion for both its third fund in 2006 and its fourth fund in 2007. The firm hauled in $1.6 billion for its second energy fund in 2004 and $950 million for its debut fund in 2003. It’s not clear how much ArcLight has raised for its fifth fund, but sources say the firm is switching placement agents amid the fundraising. MVision, which was helping ArcLight raise the fund, is off the assignment, sources say. MVision declined to comment.

As of 31 May 2010, ArcLight’s Fund IV was generating a 5.45 percent internal rate of return; Fund III was producing a 3.19 percent IRR; and Fund II was carrying a 14.6 percent IRR, according to performance data from the University of Texas Investment Management Company.

The cases of Elevation and ArcLight make clear that limited partners want to see results before placing more capital with firms they’ve backed in the past.

Fortunately, a lot of LPs, especially those with more experience, have a more patient view of private equity. Sheryl Schwartz, former head of alternatives at pension giant Teachers Insurance and Annuity Association – College Retirement Equities Fund (TIAA-CREF). Acknowledging some of the mistakes of the past few years made by GPs, she told delegates at the forum: “Buyouts are a core part of any portfolio, and if you partner with the right manager, you’ll outperform the public markets,” she said.