Sure, we reap what we sow, but history shows that the reaping gets a heck of a lot better for LBO shops if they sow after an economic contraction.
That could be great news for firms sitting on untapped vintage-2008 funds, since many economists suspect we’re already in the midst of a recession. But for those firms that began investing their latest funds a couple of years ago? Not so great news.
The United States endured a mild recession—defined as two consecutive quarters of negative GDP growth—in the winter of 1990 to 1991, while at least a decade later the economy shriveled in three non-consecutive quarters of 2000 and 2001, according to the U.S. Department of Commerce. Both contractions turned out to presage especially lucrative periods of buyout activity, as U.S. buyout shops bought low during the dark times and sold into an upturn years later.
According to the 2008 edition of Investment Benchmarks Report, published by Thomson Reuters (publisher of Buyouts), buyout shops that formed their funds in 1992, in the wake of the earlier of the two contractions, generated a pooled net IRR of 20.1 percent for their investors and an investment multiple of 2.0, between distributions and an estimate of remaining value. Firms managing vintage-1993 partnerships delivered a pooled net IRR of 19.1 percent for investors and a multiple of 2.1.
For comparison, the median net pooled IRR posted by all 1984 to 2003 vintage-year fund classes was 13.4 percent, according to the Investment Benchmarks Report. The median investment multiple for those same vintage year fund classes was 1.7.
Ten years later, history repeated. U.S. buyout firms that formed their funds in the post-contraction year of 2002 have so far generated a pooled net IRR of 21.5 percent for their investors, well above the 20-year median. Those funds have so far returned 1.6 times their backers’ money. LBO shops forming 2003 vintage funds have generated a pooled net IRR of 29.9 percent, and multiplied their backers’ money by 1.7.
Not surprisingly, two years prior to the start of these same two economic contractions turned out to be a lousy time to form a fund. Firms managing vintage-year 1988 funds generated a pooled net IRR of 11.2 percent, and multiplied their investors’ money by 1.7 times. Those managing vintage-year 1998 funds generated a pooled IRR of just 2.5 percent, and multiplied their investors’ money by a scant 1.1 times.
Should the 2008 to 2009 period also deliver a recession, it could similarly spell lackluster returns for vintage-2006 funds. Such an outcome would likely have an outsized impact on limited partner returns, since 2006 was such a banner year for fundraising. U.S. buyout shops raised $203.9 billion in 2006. That was more than three times the $67.1 billion raised in 1998, and more than was raised in the entire four-year period from 1996 to 1999.
Altogether, the 2008 IBR report analyzes the performance of 672 U.S. buyout and mezzanine funds formed from 1976 through year-end 2007. The sample represents 38 percent of the number of funds formed during those years, and 59 percent of the capital. Pooled IRRs are produced by treating all funds in a particular sample as a single fund and using their monthly cash flows to calculate a return. Here are two other highlights of the report:
• Institutional investors participating in LBO fundsfrom 1980 to 2007 would have experienced 20-year net IRRs of approximately 12.0 percent, 10-year returns of 8.9 percent, five-year returns of 15.2 percent, three-year returns of 14.4 percent, and one-year returns of 26.9 percent through year-end 2007. Those that built their portfolios more recently, from 2001 to 2007, would have experienced five year net IRRs of 21.3 percent, three-year returns of 20.6 percent, and one-year returns of 23.6 percent.
• The report provides mixed evidence for the notion that smaller funds outperform larger funds. The pooled IRR for LBO funds of $0 to $250 million in the sample formed from 1976 to 2007 generated a pooled IRR of 14.7 percent, compared with 13.8 percent for funds of $250 million to $500 million, and 12.1 percent for funds of $500 million and over. However, the median IRR of 8.7 percent achieved by the $500 million-plus funds beats the 7.9 percent achieved by the $250 million to $500 million pool and the 7.5 percent achieved by the $0 to $250 million pool.