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Where's the upside?

Funds raised in 1999 and 2000 are unlikely to return stunning results to investors following the momentary madness that hit private equity firms and their investors alike. However, as with most things, there has to be an upside. But what exactly is it?

Hindsight is a wonderful thing. Back in late 1999, if you had asked most private equity firms and their investors what they expected to happen in the next couple of years, they would never have said that the market valuations - both public and private equity - would fall to pre-1998 levels. Talk to almost anyone now and they'll tell you that internet and other technology investing was a bubble that could never have lasted and that the meltdown over the last year was inevitable.

The mention of bubbles in this context was made in many of the discussions - both public and private - at a recent gathering of general and limited partners, the European Private Equity Investment for Pension Funds, held in Stockholm and organised by SPS Conferences.

Most delegates and speakers agreed that funds raised in recent years were going to give pretty poor returns to investors - if they gave any at all. ‘The last two to three years have clearly been difficult for investors,' said Brooks Zug, senior managing director of HarbourVest Partners. ‘The funds raised in 1999 and 2000 will see the worst returns we've seen for some time.'

Looking back, it's easy to see what went wrong. Excited by the returns seen by some private equity players at the beginning of the bubble, investors rushed to get a piece of the action. New players - many inexperienced and some completely new to private equity - started setting up shop, seduced by the fast money they thought they could make. New investors started going into the market, too, convinced that they would be able to boost their overall returns. The result? A market awash with cash, with private equity firms and their investors scrambling to clinch deals and to hell with the due diligence. And now that the public markets have taken a nose-dive, private company valuations have plummeted, too. It's a great market for people buying companies; it's a terrible one for those already invested.

The more experienced players are likely to weather this particular storm and survive to raise new funds that will - hopefully - perform much better. But some of the newer and greener firms are bound to go to the wall - taking their investors' money with them. This is part of a natural shake-out process and will help make the industry increasingly professional.

Meanwhile, experienced private equity investors may be upset that funds didn't always place their money in a fully surveyed home. And rightly so. However, they will understand that these ups and downs are part and parcel of a long-term investment such as private equity. A clear illustration of private equity's cyclical nature came from Hamilton Lane managing director, Kelly Moylan. She read an extract from the New York Times, reporting venture capitalists moving away from technology investments in droves and investors being left with very burnt fingers. The extract was from 1989.

Newer investors won't have been through this type of trough before. They will be understandably nervous. However, in a ten-year investment, they should expect some downside. They should also bear in mind that losses in the first few years of a private equity investment are to be expected, even if they weren't happening a couple of years ago. ‘I just hope that new investors who committed over the last two to three years understand that this is a long-term business,' said Zug. ‘The J-Curve pattern of returns is normal. I think we all forgot that negative returns for the first three years or so are normal. As an investor, you need to build out a private equity programme over a long period of time.'

Nervousness among investors has already caused some problems for firms raising funds. Even before the events of 11 September, firms were having difficulties hitting their fund-raising targets. After the attack on the World Trade Center, many investors simply pulled back and are now adopting a wait-and-see approach. Firms at the conference agreed that the fund-raising climate was hard and some even said that they were prepared to close their latest fund below target, and then raise another sooner than they had originally planned.

This is a natural consequence of the downturn and the predictions are that, once things have settled down, investors will be looking at private equity again. But we're also likely to see some of the newer investors shrink back from private equity altogether. After all, it has happened after previous downturns. In an industry that relies on new sources of capital for its continued growth, this may seem like a negative outcome. But here's the upside. ‘The current shake-out is getting rid of the weaker firms,' said one industry observer. ‘But it is also getting rid of some of the less committed investors. This is a good thing. The industry needs steady investment from people who are able to pick the good managers, it doesn't need floods of cash. That only leads to inexperienced managers getting in on the act. And that, in turn, isn't good for the industry's reputation.'

Private equity needs new investors, but it needs committed new investors that understand what they're getting into. The new ones that stick with it will have learned from the experience. The new ones that shrink back probably shouldn't have been there in the  first place.

SPS Conferences is organising another European Private Equity Investment for Pension Funds conference on 4 December in Hamburg. For more information, please visit www.spsconferences.com

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