No Way Out

Private Equity firms buy and sell companies using money raised from Limited Partners who are savvy Institutional or accredited Individual investors. PE buyout firms used to take four to five years to spend their funds, allowing investors to receive returns gained from the sale of assets over that time. These LPs include mainly Pension and Endowment Funds, University funds and other large institutions with huge annual revenues looking for a temporary parking lot before the incidence of predictable future outflows. So they invest these funds in PE funds and try to gain max return on their investments before it is paid out. Right now the money is not flowing back in and is mainly going out.

So many PE firms who have accepted large sums of money from LPs have used up most of their commitments and are hungry for more. If $ 36 billion RJR Nabisco buyout was a one-off large deal for KKR a few years back, now these kind of deals are put together even in emerging markets. This ravenous hunger for large ticket deals is sudden and directly corresponds to the large number of PE firms active in the markets across geographies. The LPs are naturally getting jittery.

What is the reason behind this sudden one way trend…? Reasons are not hard to find.

Almost all equity markets have run up quite high and the average PE is close to 25. This is normally considered overheated in those far eastern markets and the local investors have already pulled back. The PE firms and hedge funds with their financial muscle force their way in not because they find them attractive, but due to absence of investible stories elsewhere. This is extremely risky for the investors as well as those local economies, since the borderline between fundamentals and exuberance is being redrawn and the local investors and fund managers are equally confused. Result, they end up entering at the peaking end of the curve only to have a hard landing. These markets after a fall from such heights rarely get back up for another three or four years since it takes such a long time for the painful memories to fade and for local liquidity to build-up. Restoration of faith in markets will still take some time more. The cycle has to reverse for the foreign PE players to take to these markets again ( they have to run out of options elsewhere ) which is just about one in as much as a decade.

Eventually this rubs off on those developed markets where PE fundraising gets harder by the day. With fewer exit options available, the LP investors are increasingly reluctant to commit more funds until they see returns from their earlier investments winding its way in. After all, they are just custodians of `faith money’ entrusted by employees and universities and someday they have to pay it all back. There is a limit to the interim risk that they can assume – no matter how enticing the returns be.