Will New Funds Deliver In Downturn?

Buyouts Magazine recently analyzed performance data after compiling returns for some 405 U.S., European and Asian buyout vehicles formed from 1981 to 2003. Our source: fund returns published by eight public pension funds. One striking result is the exceptional returns generated by funds raised during the previous economic downturn—2001 through 2003. Indeed, bottom-quartile internal rates of return for vintage-2002 and 2003 LBO funds, for example, came in at 18.79 percent and 19.00 percent for our sample, respectively. Those figures are actually higher than the median IRRs for funds raised any other time in the previous decade, with the exception of 2001.

Investment multiples, too, peaked for funds raised during the last downturn. Vintage-2001 funds in our sample generated a median investment multiple of 1.90x, followed by vintage-2003 funds, which generated a median investment multiple of 1.74x. Vintage years 2002 and 1994 tied at 1.70x (see chart for more vintage-year breakdowns).

“If the statistics bear this out, then funds raised over the next two years will be absolute outperformers,” said Michael Sotirhos, a partner at placement agent Atlantic Pacific Capital. “Every group we speak to says the exact the same thing: ‘The time hasn’t come quite yet, but we’re really close to the point where sellers are coming to terms with reality on a valuation basis,’” Sotirhos said. “Once that actually happens, I think you’ll see a great performance metric on everything that gets done.”

The relatively high performance of the early-2000 funds no doubt stems from good timing, having been raised just as the economy hit the skids due to the bursting of the tech bubble, the 9/11 terror attacks, and the corporate fraud cases of Enron and WorldCom. These funds had fresh caches of dry powder at a time when valuations were bottoming out. Buyout shops had the opportunity not only to buy at a discount, but were able to take advantage of rocketing valuations fueled by an unprecedented burst of credit at exit time.

Based on an analysis of nine top performing funds from vintage years 2001 through 2003, it is also helpful to have a focus, be it in a particular industry, geography or strategy.

Some of the top-performing funds from the previous downturn include Advent International’s vintage-2002 Advent Global Private Equity IV-A LP, and energy investor Lime Rock Partners’s vintage-2003 Lime Rock Partners II LP, both of which have investment multiples of 3.30x and IRRs of 54.30 percent and 57.70 percent, respectively. Both firms closed new funds earlier this year. Advent’s new vehicle is Advent International GPE VI LP, which raised a total of $10.4 billion on a $7.8 billion target and Lime Rock’s new endeavor is the $1.4 billion Lime Rock Partners V LP.

Other top performers include Lindsay Goldberg’s first fund, Lindsay, Goldberg & Bessemer LP, which raised $2 billion in 2002 and has since returned 2.36x invested capital to limited partner The Canada Pension Plan. Looking for a repeat performance Lindsay Goldberg is in the market with Lindsay Goldberg III LP, which has a $4 billion target, and has already received capital commitments of $4.48 billion, according to a regulatory filing.

Energy investor First Reserve Corp. is also a success story from the previous downturn. The Connecticut firm’s ninth fund, First Reserve Fund IX, which raised $1.3 billion in 2001 has an investment multiple of no less than 3.00x and an IRR of 48.20 percent according to CalPERS. First Reserve, too, is currently in the market raising a new fund, First Reserve XII LP, which is targeting $12 billion with a $16 billion hard cap.

As of the beginning of November, U.S. buyout firms have raised roughly $237.2 billion in new funds, dwarfing the $130 billion raised from 2001 to 2003, according to Buyouts.

But despite the readied war chests, there are some factors working against firms looking for deals in today’s marketplace. First and foremost, the financing markets today are crippled far worse than they were in the previous downturn, when buyout firms were still able to borrow enough money to avoid investing historically large portions of equity to finance their deals. Today firms are putting an average of more than 43.8 percent equity in their deals, whereas the peak in equity contributions in the previous downturn was 2002’s average of 37.3 percent, according to Standard & Poor’s Leveraged Commentary & Data.

Moreover, purchase price multiples in 2001 were at a depressed 6.0x EBITDA and increased only slightly over the next two years to 7.1x EBITDA, S&P holds. Multiples today are still close to the historically high figures of 2007. In the first nine months of 2008, the average deal had a purchase price multiple of 9.3x EBITDA.

Potential areas for today’s countercyclical plays include beaten-down sectors such as retail and consumer products, as well as financial services. Atlantic-Pacific’s Sotirhos said the impending wave of distressed companies in those sectors has a number of firms readying their war chests for the opportunity to buy low. A number of generalists, he added, have even sought to reconfigure their investment mandates to allow their new funds to invest up to half of their capital in distressed opportunities.