Private equity, an investing trade plied by 4,500 firms with $3 trillion in assets, is bracing for a shakeout that’s been brewing since the collapse of credit markets choked off a record leveraged-buyout binge.

Firms that attracted an unprecedented $702 billion from investors from 2006 to 2008 must replenish their coffers for future deals and avoid a reduction in fee income when the investment periods on those older funds run out, typically after five years. As many as 708 firms face such deadlines through 2015, according to London-based researcher Preqin Ltd.

Private-equity firms pool money from investors, including pension plans and endowments, with a mandate to buy companies within five to six years, then sell them and return the funds with a profit after about 10 years. The firms, which use debt to finance the deals and amplify returns, typically charge an annual management fee equal to 1.5% to 2% of committed funds and keep 20% of profit from investments.

While fund-raising is a routine part of the buyout business, today’s environment is anything but. Many firms are suffering from below-average profits on their boom-period funds and top executives from Carlyle Group LP co-founder David Rubenstein to Blackstone Group LP President Tony James say future returns will be far more modest than those investors got used to in the past. As investors gravitate to the best-performing managers and cut loose others, 10% to 25% of firms may find themselves without fresh money.

‘Rather Massive’
“The shakeout will be rather massive,” says Antoine Drean, chairman of Triago SA, a Paris-based firm that helps private-equity firms raise money. Drean estimates that as many as a quarter of private-equity managers will see their funding pulled by 2018.

The firms are under growing pressure to invest the capital they already have. About 28% of the money raised from 2006 to 2008 has been paid back to investors, according to Cambridge Associates LLC, a Boston-based research and consulting firm. More than $100 billion, or 14%, of the $702 billion raised, is yet-to-be invested dry powder that firms must use or lose by the end of 2013, according to Triago. That’s a record for dry powder set to expire in a single year, Triago says.

What’s more, performance has sagged, most markedly on LBOs done at the peak. Since 2007, the industry’s median return has been 6% a year, below the 7.5% that many pensions need to pay retirees and far beneath the industry’s historic average of around 13%. Notable among the underachievers are many of the megafunds, multibillion-dollar pools raised in the boom by firms including Blackstone, TPG Capital and KKR & Co.

Blackstone’s $21.7 billion fund from 2006 had a 2% net annualized internal rate of return as of December 31, according to a Blackstone regulatory filing. TPG’s boom-era funds—an $18.9 billion vehicle raised in 2008 and a $15.4 billion vehicle from 2006—were generating returns of 2.5% and a negative 4.9% annually as of June 30, according to the California Public Employees’ Retirement System, a TPG investor. KKR’s annual return on its $17.6 billion fund from 2006 was 6.9% as of September 30.

That combination of underperformance and funding needs has set the stage for a purge as investors pull the plug on the weakest firms. Only the scope of a shakeout is a matter of debate.

“There will be some carnage,” says Jay Fewel, a senior investment officer for the $73.5 billion Oregon state pension fund in Salem, Ore., which has been investing in private equity for more than 30 years. “A lot of folks raised money in the mid-2000s, when it was pretty easy. Now there are probably too many funds out there.”

Weeding Out
David Fann, CEO of TorreyCove Capital Partners LLC, which advises large limited partners such as the Oregon Investment Council and Teachers’ Retirement System of the State of Illinois, estimates the bottom quartile of any vintage, or fund-raising year, will struggle to get backers to commit to new funds. Drean at Triago says the $3 trillion in assets overseen by private-equity firms will shrink by as much as 20% in the next five years.

Erik Hirsch, chief investment officer at pension-fund advisor and investment manager Hamilton Lane Advisors Inc., expects a less draconian though still sizable culling of about one-tenth of the firms. While the industry’s five-year average return of 6% is lackluster by past standards, it still topped the Standard & Poor’s stock index’s 0.2% figure over that span.
“There will be a weeding-out process over time,” Hirsch says. “It’s not going to happen overnight.”

It wouldn’t be the first time that firms see their assets diminished. In the early 2000s, the bursting of the technology-stock bubble caused two of the most formidable buyout firms of that era to crater: Hicks Muse Tate & Furst, based in Dallas, and Forstmann Little & Co., based in New York. A host of venture capital shops were wiped out from 2000 to 2002, as venture assets fell by almost 15%, according to Preqin.

Hicks Muse, led by Tom Hicks, a charismatic financier who owned the Texas Rangers professional baseball team, in 1999 raised a $4.1 billion fund, then second in size only to that of Henry Kravis’s KKR & Co. Ted Forstmann was a buyout manager known for publicly criticizing Kravis’s habit of financing deals with junk bonds, calling it reckless.

Soured wagers on telecommunications and technology torpedoed Hicks’s and Forstmann’s operations. Forstmann lost a total of $2.5 billion on two companies, XO Communications Inc. and McLeodUSA Inc., that were restructured in 2002, regulatory filings show. The loss erased close to half his firm’s capital base, a person familiar with the matter said.

Forstmann never raised another fund. He bought just two large platform companies after 2001 and sold most of his firm’s holdings. Then he died in 2011. Kathleen Broderick, a Forstmann Little director, didn’t return messages seeking comment.
Hicks Muse lost more than $1.5 billion of investors’ money in about a dozen deals over three years, mostly in telecommunications. The 1999 fund dealt investors a loss of 32%, according to the Oregon state pension. Hicks raised 60% less money in 2001 for his next fund, and by 2005 the firm had sundered. Hicks along with top partners Charles Tate and Michael Levitt, left the firm, while its London team, which had a good track record, split off. Hicks Muse soldiered on under a new name, HM Capital Partners, a shadow of its old self.

Lowered Expectations
Today, the industry’s largest firms are cushioned from such risk because they have morphed into vast, diversified vendors of everything from real estate to credit and hedge funds. That’s not to say they’re immune from fund-raising woes.
Rubenstein, co-chief executive officer of Carlyle, the second-biggest alternative-asset firm, has been preparing investors for a future of lower returns from buyouts. “We do think that private-equity returns probably will come down compared to the historic highs we had 10 years ago,” Rubenstein said in a November interview on Bloomberg Television. Carlyle, which produced average gross returns of about 30% a year over its 25-year history, is now targeting gains of about 20%, he says.

Carlyle’s $13.7 billion buyout fund from 2007 posted a 10% net internal rate of return through September 30. That surpassed the returns of other boom-era megafunds. A year ago, the Washington, D.C.-based firm started raising a new flagship fund with a target of $10 billion, corralling more than $5 billion through December 31, according to a Carlyle investor. Carlyle spokesman Chris Ullman declined to comment on fund-raising.

Smaller firms that haven’t diversified are facing bigger risks. J. Christopher Flowers, who raised $7 billion in 2006 to invest in financial services companies, has delivered a negative 23.3% annual return on a fund valued at just 0.35 times of cost as of September 30, according to the Oregon state pension. The 2011 collapse of MF Global Holdings Ltd., a broker headed by Flowers’s friend and former Goldman Sachs Group Inc. cohort Jon Corzine, cost Flowers and his backers almost $48 million.

Flowers hit the jackpot shortly before starting his New York-based JC Flowers & Co. buyout shop in 2001. He scored more than a sixfold windfall on a $1.1 billion bailout he led in 2000 of Shinsei Bank Ltd., formerly Long-Term Credit Bank of Japan Ltd. Later investments in Germany’s Hypo Real Estate Holding AG and German shipping lender HSH Nordbank AG, along with a follow-on bet on Shinsei, foundered.

Although the $7 billion fund’s investment period ran out in mid-2012, according to a person familiar with the matter, Flowers kept in the game by closing a new, $2.3 billion fund in 2009. He raised most of that in 2008, said the person, asking not to be named because the fund is private.

The newer fund has generated a cumulative net return of about 10%, according to a September 2012 report to investors that Bloomberg obtained. Yet his topsy-turvy ride may make it hard to win converts for future pools, according to four institutional investors, who asked not to be named. Two of them, who invested with Flowers in the past, said they would not do so again.

Jordan Robinson, JC Flowers’s head of investor relations, declined to comment.

Elevation Partners is another prominent outfit struggling under subpar returns. Backed by venture capitalist Roger McNamee and pop star Bono, Elevation started in 2004 with a $1.9 billion inaugural fund. By early 2010, bad bets on smart phone maker Palm Inc., magazine publisher Forbes Media LLC and dubbing company SDI Media Group, a provider of dubbing and subtitling services, had dropped its annual return to minus 12%, according to the Washington state pension fund.

Investors that year rejected the fund’s request to extend its soon-to-expire investment period by a year, which would have kept in place fees on the Menlo Park, Calif.-based firm’s $500 million of dry powder, three people said.

‘Crowded Out’
Another of Tom Hicks’s offspring, Lion Capital LLP, Hicks Muse’s former European arm, has fared better, raising more than 1.5 billion euros so far for its third fund, a person briefed on the matter says.

Those that shut down, like Candover Partners Ltd., an old-line British firm pummeled in the financial crisis, are exceptions. And Candover, like many foundering firms, spawned an offshoot after closing down in 2010, Arle Capital Partners LLP, that took over its holdings and operations.

“They don’t disappear quickly,” says Kevin Albert, global head of business development at private-equity fund-of-funds manager Pantheon Ventures LLP. “The shakeout will occur, but it will take time.”

After the industry’s weakest shops are swept out, some expect that investors will drop run-of-the-mill performers and move to concentrate their bets on a handful of larger firms with strong records. That’s partly because many pensions that have invested with 100 or 150 firms are seeking to cut back to a more manageable number with better returns.

“A lot of large investors are doing triage on their portfolios,” says Kelly DePonte, a managing director at pension advisor Probitas Partners LLC in San Francisco. “They’re doubling down on the firms they like, while not re-upping with other firms,” he says, citing moves by the country’s two biggest pensions, the California Public Employees’ Retirement System and the California State Teachers’ Retirement system.

The Ontario Teachers’ Pension Plan said last year it would cut the number of venture and private-equity managers it invests in.

“Nobody needs just another middle-market group,” DePonte says. “Unless you have a distinct advantage and strong track record, you’re at risk of being crowded out.”