A grand paradox makes private equity puzzling

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Two weird things are happening in the private equity (PE) world.

On the one hand, there’s about $100 billion capital that was raised in the years leading up to the financial crisis but not invested. With five years or so to use that “dry powder”—a period that for many funds is up at the end of this year—they are jumping to make investments before they have to return money to investors. And investors, disappointed with the recent lackluster returns in PE, may not want to put more money in. That could be the reason why 24% fewer funds successfully closed fundraising rounds in 2012 than did in 2011.

On the other hand, there’s an opposite push happening on the regulatory end. Regulators are forcing banks to amass extra capital to protect them (and the financial system) against risk, which means they have less cash to spare for investing. New regulations like the Volcker Rule also restrict them from investing client money in risky ventures that could bring high rewards. Their clients–particularly institutional investors and very rich individuals–will be looking elsewhere for high-risk, high-reward investments. Among those are the non-bank financial institutions (“shadow banks”) which, because they don’t take deposits, are typically less heavily regulated. That means, in particular, hedge funds and private equity.

In short, just as the PE firms’ sources of funds are starting to dry up, demand for their services could be increasing.

How much of an edge their laxer regulation will give PE firms remains to be seen. At least in the US, the Financial Stability Oversight Council (FSOC) can now request confidential information from non-bank financial institutions. But it’s still too soon to tell how strict this oversight will be. Either way, the pull-back in traditional banking means there are new opportunities for private equity and other alternative asset managers. So far, they already seem to be cashing in on this; buying ships, gobbling up distressed debt, and managing new and larger investments.

It also remains to be seen how many funds are in the game when the “dry powder” left over from the financial crisis dries up. At least some are bucking the squeeze. Carlyle Group’s earnings statement today demonstrates the disconnect: its distributable earnings (the amount it actually pays out to investors) fell 24% from the fourth quarter of 2011, underwhelming analysts. At the same time, the fund was raising more and more money: $4.4 billion in the fourth quarter alone (and $14 billion for the year) versus $6.6 billion in all of 2011.