Analysis Of Private Equity Business

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That belief leads to his forgiving mood: “Obviously, we will pay a little bit closer attention,” he says of his fund’s private equity investments. But when we talked about the terrible time Apollo was having, he said, “Their bread and butter is really dislocated markets like we are in now. The story will unfold over time, but I’m not going to lose a lot of sleep over Apollo.” Nor, it seems, are most investors. Despite its multiple calamities, Apollo managed to raise almost $15 billion by December for its next fund.

They should be more wary. The returns of the top performers are unlikely to hold up. The best-performing funds were the ones that dived headlong into the bubble investments. A full 37 percent of the money committed to private equity since 1980 was pledged in 2006 and 2007. That suggests that in a few years, those top performers won’t stay on their perch. “My guess is that the megafunds will have lower returns than the smaller funds,” says the University of Chicago’s Kaplan. “Given that the megafunds had performed well in the past, that would mean that persistence will not occur. Historically, size is the enemy of persistence.”

I expect pension funds and endowments will just ignore that prospect and keep giving money to private equity firms anyway. Tony James, Blackstone’s chief operating officer, says, “Our limited partners tell me private equity is the single best performing asset class by a lot, but there are parts of cycles that don’t look great. Now there are great opportunities that don’t require much debt.” He adds, “It’s one of the greatest times in history to invest money.”

That is why the industry won’t see further shakeout. Not that things will be rosy by any means. The private equity industry cannot lever up its investments nearly as aggressively as it used to, because banks are no longer willing to lend to them. (Private equity companies hope to compensate by buying businesses so cheaply that they can still make adequate returns.) Dealing with the disasters of 2006 and 2007 will require an enormous amount of time and resources, which will drain capital for new investments. And few private equity firms have adequate skills when it comes to distressed investing, despite the fact that they have raised money to invest in those very situations.

Furthermore, while these firms believe they have raised the money for their follow-on funds, their desperate investors are starting to resist. By the end of last year, TPG and the British firm Permira were letting their investors out of capital commitments, a sign that the leverage of the private equity firms may be ebbing. So the new funds will most likely be much smaller, meaning private equity as an industry will be less lucrative.

Despite all of that, when markets and the economy go south, some investment opportunities become more attractive. Fed-up investors hold on to the hope (which in some cases becomes reality) that the private equity firms will be able to make superior investments in this “vintage,” as the jargony industry term has it. Even sophisticated investors who know that the game is rigged think the time is right. I spoke to one former private equity professional who now sits on the other side, at a family office, making investments. “I see no consequences” for the private equity firms from having made all those stupid investments in the bubble years, he told me.

His own experience bears that out. He had investments in a private equity fund of funds that had committed to a TPG fund that had invested in Washington Mutual. The $20 billion TPG fund had put 2.5 percent into WaMu, a disaster, and was offering investors a chance to reduce their capital commitments, but only by 10 percent. His family office’s direct exposure to the WaMu failure was paltry. Given that 95 percent of the fund’s capital is left to be invested in what he is convinced will be a good vintage, he says, “I’m psyched to be in it. I’m going to double my money. You have an element of robbery, and there are never consequences, but people are happy to be in the next fund.”

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