OK, you gotta help me. Private equity is basically levered equity. Yes, the claim to add value in various ways, but many academic studies question that theory. The big source of profits is leverage and financial engineering. Neither of those approaches were spectacularly successful in any sector I can think of in 2008.
In addition, many PE firms have companies in their portfolio that are in a world of hurt right now, due to a combination of fundamentals that fell off a cliff, high debt loads, and in many cases, debt maturing in the next year or so.
So how can PE companies (on average) possibly report returns that are better than equity averages last year? It strains credulity. Leverage cuts both ways, and it most certainly would not, in most cases, have done PE owned firms much good last year.
And making the expected mere 20-30% losses (versus public market declines of more like 40%) comes when PE firms are held to more rigorous standards in valuing their holdings. That alone should have a return-depressing effect.
To its credit, the Financial Times article does say the losses could be considerably worse than the rumored level.
From the Financial Times:
Private equity firms will in the next few weeks send their investors grim letters telling them just how much – or little – the companies they invested in are worth today, with many executives saying the reported fall in value will be 20-30 per cent.
According to regulations that are applied this year for the first time, private equity firms are required to value their companies at what they would be worth in the market today rather than merely disclose the original cost of the investment.
By some calculations, the actual losses could far exceed 30 per cent, since many of these companies were bought and taken private at the peak of the financial frenzy. In many deals – particularly ones struck in 2006 and 2007 – private equity firms paid a 25 per cent premium to public market levels to take their targets private.
They then put massive amounts of debt money into their companies, suggesting the drop in value should be more like 60 per cent, some industry experts estimate.
With public markets down about 40 per cent, the equity may well be worthless today – save for the fact that the private equity firms have years to try to restructure and restore value to their companies.
Once year-end figures are known, many cash strapped investors, themselves reeling from losses, are likely to put more pressure on private equity firms to refrain from doing deals that would require them to write more big cheques.
These investors are also expected to dump more of their private equity holdings in the secondary market.
In the dot-com bust, investors demanded that venture capital firms reduce the size of their funds (my recollection the shrinkage was on the order of 50%), which a dramatic reversal of fortune for the funds, since most tried to cover their overheads and salaries with the management fee (the 2% of the typical “2 and 20” formula). And of course, in that environment, upside fees were pretty much non-existent. Most business don’t cope well with a 50% cut in what they took to be annuity revenues (and more like a 90+% fall in top line when upside fees are included)