Billions Pour Into Private Equity

Every day, it seems, private equity investment firms are announcing new and larger funds. Blackstone Group said last week it would raise $11 billion from pension funds and other investors to put capital to work in a variety of industrial companies.

If it gets the money, the 20-year-old firm founded by onetime Commerce Secretary Peter G. Peterson would top Goldman, Sachs & Co., which raised $8.5 billion last month, and Carlyle Group, a politically connected Washington-based firm that raised $10 billion in March for investments in U.S. and European companies.

Pension funds, college endowments, family trusts and just plain rich folks are putting capital into private equity funds and their short-term cousins, hedge funds. They’re all chasing higher payoffs than the single-digit average annual returns widely expected on publicly traded stocks or corporate and U.S. government bonds.

Private equity funds showed returns averaging 23.5% in the last year, according to Cambridge Associates research. Small wonder that worldwide totals of private equity have passed $350 billion, according to Pensions & Investments magazine. Hedge funds, now numbering about 8,000, are said to hold more than $1 trillion.

The main difference between private equity funds and hedge funds is the length of commitment for investors: Private equity is a longer-term investment, typically five to seven years; in contrast, hedge fund investors generally can withdraw their money once a quarter. Hedge funds also make use of short selling -- a bet that stock prices will fall -- and exotic trading mechanisms for immediate gains.

Private equity funds have been active recently in some high-profile corporate investments. For example, Ripplewood Holdings of New York has agreed to pay $2.1 billion to acquire Maytag Corp., the troubled Newton, Iowa-based maker of home appliances. Hedge funds are helping to finance America West’s merger with US Airways and sports entrepreneur Malcolm Glazer’s purchase of British soccer institution Manchester United.

Private equity has always been the little guy’s mode of financing -- the funds that back entrepreneurial firms or help with the transition when family members want to hand off the reins to others. Southern California, with more than 5,000 small to mid-sized companies, is an enormous marketplace for private equity and small-scale investment banking.

As a funding mechanism for small business, private equity differs from venture capital in that it is intended for cashing out a retiring family or enabling an existing business to expand, as opposed to launching start-ups.

Right now for example, SFE Investment Counsel, a fund grown out of the Los Angeles brokerage Stern Fisher Edwards, is raising $4.5 million to help MTK Inc. expand in Latino specialty foods. Local investment banker Barrington Associates is completing the merger of Alterna Inc., a Beverly Hills hair-care firm, into Markham Prestige Group.

“This area has so many family companies seeking capital to expand or to sell out, it’s a breathtaking market,” says Daniel Conway, managing director of Focal Point Partners, a San Fernando Valley based firm that is helping to finance ethanol projects in northern California and Oregon.

So how did a traditional mode of financing for small companies become the rage for giant institutional investors?

In a word: diversification.

“Modern portfolio theory demands that you allocate your assets among many alternative investments -- large companies and small, real estate, high-yield bonds, private equity and so forth,” explains Michael Tennenbaum, senior partner of Tennenbaum Capital Partners. Tennenbaum’s 9-year-old Santa Monica firm has $3.5 billion in institutional funds invested in local companies such as WaterPik Technologies Inc. of Newport Beach as well as in high-interest loans on aircraft belonging to Delta Air Lines and Northwest Airlines.

Ironically, 20 years ago, prudent fund managers were practically forbidden to participate in alternative investments of the kind pioneered by leveraged buyout firm Kohlberg Kravis Roberts and Michael Milken, the former impresario of high-yield, or “junk,” bonds. Now fund managers are practically required to devote assets to alternative investments. The world moves on.

How do private equity firms make such high returns on investment? Partly through leverage. The funds borrow four to five times the amount of equity raised from investors and so are able to commit much more capital to companies and situations. If deals succeed, the return on the equity portion is correspondingly larger; if deals fail, the losses can be quick and total.

The level of risk may be higher for private equity investors, but the funds can try to limit the downside by helping manage the companies they buy into, whether by sending in skilled executives or steering policies. At Maytag, Ripplewood’s chief executive, Timothy Collins, a onetime Lazard Freres banker, says he plans to help management expand internationally by making acquisitions and joint ventures. “I’ll bring capital to them, “ Collins says.

Still, some Wall Street analysts are skeptical of Ripplewood’s long-term interest in Maytag.

Nicholas Heymann of Prudential Securities believes that Ripplewood will “lean on Maytag’s unions to open the contract and reduce wage and benefit costs.” David MacGregor of Cleveland’s Longwood Research thinks Ripplewood will simply try to sell Maytag to Samsung or LG Electronics of South Korea, allowing those appliance makers to gain an instant distribution network with U.S. retailers.

Whatever happens, Maytag will be an interesting deal to watch for pointers on private equity.

For all the current fanfare, private equity financing is at a crossroads. With so many funds and so much money chasing opportunities, the markets are crowded and returns may be diminishing.

Robert Arnott, head of Research Affiliates, a Pasadena investment firm and editor of the Financial Analysts Journal, says investors shouldn’t expect indefinite high returns from private equity and hedge funds. Not that they won’t be good investments, he said, but they “will just take longer to show their results, good or bad.”

Indeed, Tremont Capital Management, which keeps track of hedge fund performance, reports that in the first quarter hedge funds on average earned less than 1% and had negative returns in April. The Securities and Exchange Commission is bringing hedge fund investment advisors under increased regulation, demanding more disclosure of their dealings, beginning next year.

That may drive some hedge fund operators from the field, although big private equity firms such as Carlyle are contemplating starting hedge funds.

In any event, private equity will continue to evolve. In fact, Carlyle Group is contemplating a public offering so that small investors can jump into the game.

Of course, that may be the surest sign that the big returns in private equity are over.