Alan Murray on the Buyout Era

The esteemed Alan Murray had a nice piece in the WSJ this week. In it, Murray shed light on the buyout bonanza, and, more importantly, the implications behind it. Things are looking up in buyout land, but perhaps only for the buyout kings themselves. Everyone is chatting about KKR's recent IPO of KKR Private Equity Investors. The offering was tripled in size today to $5 billion, given demand from investors. You can track the shares here. However, KKR got it's money and will likely reap the benefits of Joe Schmo's insatiable appetite for buyout deals. And can you blame Average Joe's for salivating at KKR's or any other PE shop's returns? They are high and they are relatively consistent. But as the article below from Alan Murray points out, days could be numbered for many investors in private equity funds. The end result is yet to be seen, but following the herd in the past (see the tech boom and impending bust) has not been the best way to go.

Business Council
Welcomes Buyout Kings
May 3, 2006; Page A2

When the chief executives of the Business Council meet in Washington this morning, they'll have an unusual new member in their midst: buyout king Henry Kravis.

For three quarters of a century, the elite council has been a preserve of big-company CEOs for discussing public policy. But this year, the group has let the barbarians in the gates.

Along with Mr. Kravis, new members include Robert Johnson, founder of Black Entertainment Television, who recently started a buyout fund with backing from the Carlyle Group. Carlyle's David Rubenstein and Blackstone Group Chief Stephen Schwarzman may be inducted soon, as well.

The group's membership change, engineered by General Electric CEO Jeffrey Immelt, is a sign of the times. Private-equity firms are no longer hammering to break into the ranks of respectable big business. They are big business.

And they are getting bigger. Texas Pacific Group just raised a record $14 billion for its new buyout fund. Blackstone and Mr. Kravis's Kohlberg Kravis Roberts are both scrambling to close funds that will top that. KKR is also leading the way in tapping public money, raising $5 billion on the Amsterdam stock exchange.

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All of which ensures that this will be private equity's biggest fund-raising year in history. It's only a matter of time before the biggest private-equity deal of all -- KKR's $31 billion buyout of RJR Nabisco in 1989 -- loses its place in the record books.

Is this surge in private equity a good thing? Well, maybe. The buyout kings claim they do a better job of running businesses than their public-company counterparts. And investors claim that, for the past five years at least, private-equity investments have delivered clearly superior returns.

But I think there are a few reasons to worry. Among them:

1) The growth in private equity is being driven by the availability of funds, not the availability of deals.

Don't be misled by all the talk of public-company CEOs wanting to go private to escape Sarbanes-Oxley or avoid the short-termitis of the public markets. Honest folks in the private-equity business will admit that the biggest reason buyout firms are raising megafunds this year is because investors are eagerly throwing money at them.

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Alan Murray says³ the Business Council's membership change may be a sign that private-equity firms are big business.

2) This isn't the "smart" money.

The early folks to get into this game -- like the Yale Endowment or the Oregon state-pension fund -- made tidy profits. The guys piling in now are chasing the herd. They include some corporate-pension funds, as well as large state-pension funds governed by politicians and union bosses and run by civil servants who like being wined and dined and taken on golf outings by the buyout kings.

3) The incentives are skewed.

Buyout-fund fees are not only huge, but also give fund managers a handsome stream of earnings even if they don't succeed in getting superior investment returns. Standard fees can be as much as two and twenty: That means the buyout firm collects a management fee equal to 2% of the fund's invested capital each year, in addition to its 20% of the profit. For a $14 billion fund, that's $280 million a year for just raking in the money, even if its investments fail to perform.

4) It will be a decade before investors really know whether they've made money.

If this were a normal market, bad buyout funds would get poor investment results and go out of business. But in the private-equity world, investors are required to leave their money in place for 10 years. If a fund fails to deliver, the investment manager who made the investment is likely to be long gone before anyone knows better.

Pension-fund managers say they have to invest in private equity because the returns are higher. But that's not necessarily true. Antoinette Schoar, professor of finance at the Massachusetts Institute of Technology, says her research shows that on average, returns to private equity, after taking fees into account, don't beat the S&P 500. The top quartile of funds have done very well, she says, but that's been offset by poor performance in the other three quartiles.

The private-equity guys deserve their seat at the Business Council's table. But whether they will earn the big paychecks investors are giving them remains to be seen. When the day of reckoning comes, some pension funds are likely to find they've squandered their beneficiaries' hard-earned retirement dollars paying stellar fees for less-than-stellar funds.

Write to Alan Murray at business@wsj.com⁴

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