Still flush with cash from funds raised before the financial crisis, private equity firms are increasingly finding themselves in a pickle. They raised a whopping $702 billion from optimistic investors between 2006 and 2008, when PE firms and their investors were making big bucks off a leveraged buyout (LBO) boom.
But since then they have quite a bit of that money left. The lack of sound investment opportunities has left PE firms holding some 14%—around $100 billion—of those funds as what’s called uninvested “dry powder,” according to Triago, a Paris-based firm that helps PE firms raise capital. The can’t hold it indefinitely, though—and therein lies the problem. Most PE funds agree to allow investors to redeem any funds that haven’t been invested within five years. And for many funds, that date is the end of 2013.
In the past, pension funds have forked over piles of cash to shrewder PE firms in the hopes that fund managers can generate the minimum 7.5% returns promised to retirees and management. For years, the PE industry was yielding 13%—reducing the amount of capital companies and governments had to set aside to fund employees’ future benefits. But since 2007, PE funds have, on average, yielded just 6%. Corporate pension funds have already been taking massive write-downs for not properly funding their pensions: AT&T and Verizon both suffered multi-billion dollar hits this quarter because they had to invest more capital in future retiree benefits. That’s less money to invest in private equity. In addition, considering the poor returns of PE funds in the last few years, some of these investors are losing faith in the industry altogether.
The result? PE firms could get wiped out in a hurry. As Bloomberg reports, dismal investment returns and the current shortage of prospective investors “has set the stage for a purge” of the weakest firms. “The shakeout will be rather massive,” Antoine Drean, chairman of Triago, told Bloomberg, projecting that by 2018, around one-quarter of private-equity managers could have their funding pulled.
The dry-powder pileup is likely to drive a “dumpster-diving” campaign for many firms on the edge, as we pointed out back in October. As the redemption trigger at the end of 2013 nears, it behooves them to sink cash into whatever they can find. This ticking clock is also part of the reason investors drooled over a proposed leveraged buyout of Dell. With so much cash on hand, private equity players are hoping that the Dell deal signals the start of a bright period for buyouts. As 2013 wears on, we can expect both wilder deals to be made and for prices of attractive assets to climb.