Private equity, an investing trade plied by 4,500 firms with US$3 trillion in assets, is bracing for a shake-out that has been brewing since the collapse of credit markets choked off a record leveraged-buyout binge.
Firms that attracted an unprecedented US$702 billion from investors from 2006 to 2008 must replenish their coffers for future deals and avoid a reduction in fee income when the investment periods on those older funds run out, typically after five years.
As many as 708 firms face such deadlines before the end of 2015, according to London-based researcher Preqin.
Private-equity firms pool money from investors with mandates to buy companies within five to six years, then sell them and return the funds with a profit after about 10 years.
The firms, which use debt to finance the deals and amplify returns, typically charge an annual management fee equal to between 1.5 and 2 per cent of committed funds, and keep 20 per cent of profit from investments.
While fund-raising is a routine part of the buyout business, today's environment is anything but. Many firms are suffering from below-average profits on their boom-period funds, and top executives from Carlyle Group co-founder David Rubenstein to Blackstone Group president Tony James say future returns will be far more modest than those investors became accustomed to in the past.
As investors gravitate to the best-performing managers and cut loose others, 10 to 25 per cent of firms may find themselves without fresh money.
"The shake-out will be rather massive," said Antoine Drean, chief executive of Triago, a Paris-based firm that helps private-equity firms raise money. Drean estimates that as many as a quarter of managers will see their funding pulled by 2018.
The firms are under growing pressure to invest the capital they already have. About 28 per cent of the money raised from 2006 to 2008 has been paid back to investors, according to Cambridge Associates, a Boston-based research and consulting firm.
More than US$100 billion, or 14 per cent, of the US$702 billion raised, is yet-to-be invested dry powder that firms must use or lose by the end of this year, according to Triago. That is a record for uninvested funds set to expire in a single year.
What's more, performance has sagged, most markedly on buy-outs done at the peak. Since 2007, the industry's median return has been 6 per cent a year, below the 7.5 per cent that many pensions need to pay retirees and far beneath the industry's historic average of near 13 per cent.
Notable among the underachievers are many of the mega-funds, multibillion-dollar pools raised in the boom by brand-name houses such as Blackstone, TPG Capital and KKR. Blackstone's US$21.7 billion fund from 2006 had a 2 per cent net annualised internal rate of return as of December 31, according to a Blackstone regulatory filing.
That combination of underperformance and funding needs has set the stage for investors to dump the weakest firms.
"There will be some carnage," said Jay Fewel, a senior investment officer for the US$73.5 billion Oregon state pension fund, which has been investing in private equity for more than 30 years. "A lot of folks raised money in the mid-2000s, when it was pretty easy. Now there are probably too many funds out there."