Damage From Credit Bubble Revealed

Top-quartile domestic buyout funds from that year are so far producing a 1.25x investment multiple for their investors, and a 9.34 percent IRR. Those figures are based on results of 80 2006-vintage funds, generally through March 31. The median performing 2006 fund has generated a 1.16x multiple and a 5.62 percent IRR, while the bottom quartile is marked by a breakeven 1.00x multiple and an IRR of -0.55 percent. See chart on page XX.

By comparison, top-quartile funds from 2005 (a universe of 71 funds) have posted returns topping 1.40x, with an IRR of 10.7 percent, while those from 2004 (44 funds) scored at least a 1.85x investment multiple and a 23.39 percent IRR. Across all domestic buyout vintages, a top-quartile fund returned at least 1.90x with an 18.78 percent IRR.

These findings are especially significant because 2006 also marked the middle of the great fundraising boom of the last decade. As previously reported by Buyouts, U.S. fund sponsors raised over $150 billion in 2005, and some $200 billion in 2006, before topping out at close to $300 billion in 2007. By contrast, top-performing vintage years such as 2002 and 2003 coincided with only modest fundraising tallies of less than $50 billion, meaning that relatively few LPs benefited from their outperformance, while a great many more may have bought into the later, potentially lackluster vintages. Partly as a result of the poor recent performance, some market watchers already are predicting a crunch in coming years, with as many as half of today’s GPs disappearing over the next decade or so.

There is a chance that the performance of 2006 domestic buyout funds will improve with time, thanks to the noted J-curve effect.Typically for their first five years, funds are in investment mode, which makes them more likely to show negative results, as sponsors draw down commitments and management fees. Only when they reach the harvest period does it begin to become meaningful to start examining their returns. But that is also the reason that the 2006 vintage year is the youngest cohort of funds in our study. Still, we know that many 2005 and 2006 vintage funds invested rapidly during a credit bubble that enabled them to pay higher prices for companies than they otherwise might have; those funds then had to contend with the credit bubble bursting in mid-2007 (making refinancing difficult), a financial crisis and bear market in 2008, and an economic recession that lasted from late 2007 until mid-2009.

The return pattern that has emerged over the decade from 1995 to 2006 also illustrates another truism of the industry: Funds raised in bad economic years tend to outperform funds raised in years with stronger growth; over the life of such funds, of course, bad economies give ways to good ones, while strong economies give way to financial crises and other misfortunes. Indeed, the strongest performing vintages over the course of our study were from the slump years of 2002, whose top-quartile funds returned 2.18x with and IRR of 34.6 percent, and 2003, when top-quartile funds returned 2.17x with a 31.55 percent IRR.

Investors in the top vintages also had the greatest chance of moonshot returns. The years 2001 and 2003 were the only times that IRRs for top individual funds exceeded 90 percent (95.3 percent in 2001 for T3 Partners II LP, which returned 3.2x, and 94.2 percent in 2003 for GCP Co-investors LLC, with a stunning 12.3x return.)

All told this year, we were able to identify some 520 funds dedicated to domestic buyouts, up from 443 in last year’s report, from nearly two dozen limited partners that disclose their fund returns on their Web sites, in financial documents, or through freedom of information act requests, up from nine last year. And we were able to conduct a more comprehensive survey of the alternative investment market, ultimately finding some 1,365 funds in a variety of investment strategies, including venture capital (see table, page XX). Note that not all investors report both their investment multiples and IRRs; some report neither. And the investors caution that their internal calculations might not be comparable with those of others, or with the sponsors’ own calculations of their funds’ performance. For more information on our methodology see page XX.

Among the investment strategies that we reviewed, domestic buyout fund performance from all vintage years studied was exceeded only by their international counterparts (137 funds), which showed top-quartile results exceeding 2.1x with a 22.79 percent IRR. Domestic venture funds, by contrast, showed the lowest top-quartile returns, 1.36x with an 8.6 percent IRR (411 funds). And bottom-quartile domestic and international VC funds (45 funds) were the only category of investments to show negative IRRs across all vintages, at -5.8 percent and -1.34 percent, respectively.

With the larger pool of LP reports to work with, we also are publishing, for the first time, a list of bottom of both top-decile and bottom-decile domestic buyout funds—see pages XX. For each of the funds identified as a bottom-decile performer here, the staff of Buyouts reached out to the sponsors to confirm the numbers and to provide an opportunity for them to offer explanations. Those replies are included in the footnotes, as warranted.

We should note that 10 of the bottom-decile funds are from 2006, the largest vintage cohort represented in that table; their five-year investment periods would normally extend to 2010, encompassing the credit crisis years of 2008 and 2009, when many sponsors asked LPs for extensions.

With well-time exits, no doubt some of these bottom-decile funds will work their way into higher tranches. Their investors will be rooting for them.