As chief investment officer for the University of Chicago’s $5 billion endowment, Peter Stein is under the gun.
He needs to earn about 10 percent on his investments annually just to support the current budget and to cover higher education inflation.
To grow the endowment, he needs to do more.
“Ten percent isn’t good enough,” he said.
So Stein is increasingly turning to “alternative investment” vehicles such as private equity and hedge funds, whose returns have been putting plain-vanilla stocks and bonds to shame.
Stein’s strategy is one reason that private equity firms have the wherewithal to do deals on the scale of the leveraged buyout announced Sunday for Chicago-based Equity Office Properties Trust. The transaction is valued at about $20 billion, plus the assumption of $16 billion in debt.
There’s more to come for private equity firms, which buy companies, whip them into shape and eventually try to make a profit by taking them public or selling them to another buyer. The buyout firms are expected to continue raking in billions of dollars from a wide range of investors.
“I see private equity continuing to be red hot,” said industry blogger Dan Primack. So-called alternative investments, which include real estate, private equity funds and hedge funds, are expected to reach record levels by 2007, according to a recent survey by Russell Investment Group.
Ft. Worth-based Texas Pacific Group and Washington, D.C.-based Carlyle Group are each looking to raise about $15 billion in their latest funds.
Blackstone Group has boosted its latest private equity fund to more than $20 billion.
Such fundraising is made easier as investors see the profits that buyout firms have been racking up. Returns at private equity firms have exceeded both the Standard & Poor’s 500 and Nasdaq over the past one, five and 10-year periods, and “can be north of 24 percent in a good year,” said Bob Filek, a mergers and acquisition specialist at PricewaterhouseCoopers.
But not always, of course, and some observers caution that, with the recent deluge of private equity money, some firms may be overpaying.
“There may be too much capital chasing too few opportunities,” said Carl Tannenbaum, LaSalle Bank’s chief economist. “There have been questions raised about whether risk is being appropriately priced. They may be taking on too much risk, or not being paid adequately for the risk they are taking on.”
Marc Sacks, senior managing director for Mesirow Private Equity Investments Inc., part of Chicago-based Mesirow Financial, said most of the increase in private equity investing has come from pension funds that are “reaching for yield” to make certain returns.”Given the modest expected returns of the stock market over the next three to five years, stocks and bonds are not going to get” them there.
High returns also have wealthy investors salivating.
“There is a high level of interest among our highest net worth families and family offices to be more involved in alternative investments,” said Jack Ablin, chief investment officer for Harris Private Bank. Demographic trends are also working in private equity firms’ favor.
“You’ve got some superwealthy people. They have the means and the long horizon for risk,” said Tannenbaum. “An old-fashioned equity index fund is boring to them. They’re really able to think about buying companies. Private equity gives them the opportunity to be more advanced in their investment strategies.”
Internationally, “big areas of growth are the Middle East, with interest from Dubai and Saudi Arabia immense,” said Primack, editor of PrivateEquityHub.com.
Back on the market
But there could be a downside to all of the activity by private equity firms.
“In the near term this is good for shareholders because they’re bidding up companies that public investors hold, but we’re already starting to see a flip side,” Harris Bank’s Ablin said. “A lot of private equity firms are throwing IPOs back onto the market, and it remains to be seen whether they’ll be viable investments.”
Rental car firm Hertz, for example, debuted last week to lukewarm investor interest. Analysts said it was a quick flip from private to public while carrying a massive debt load.
Indeed, while University of Chicago’s Stein is sinking more money into alternative investments, he is raising the bar, emphasizing quality more than quantity.
“We are making significant commitments to the area, but we’re making them very carefully because there’s so much money flooding in,” said Stein, 43. “We’re making fewer, larger and higher-conviction commitments.”
Private equity allocations by U.S. investors–the percent of assets devoted to that investment–are expected to rise to 7.9 percent in 2007, an increase from 7.3 percent in 2005, according to Russell.
No one, not even the Federal Reserve, has a definitive tally of how much money has been invested by private equity funds. According to the Russell survey, commitments by 176 North American firms fell from $220 billion in 2001 to $137 billion in 2005.
While that fact does not seem to jibe with the spate of private equity deals announced recently, Paul Stewart, co-founder of PS Capital Partners, a Milwaukee private equity firm, thinks he has an explanation.
There are two types of private equity investors, Stewart said: venture capitalists who invest in early-stage companies to help them grow, and investors who do leveraged buyouts of established companies.
After 2001 the venture capital investors drew in their horns, but the leveraged buyout investors never went away.
“The real story has been the amount of money put into private partnerships that go out and seek leveraged buyouts. That has grown dramatically,” said Stewart. “There’s enormous purchasing power out there looking for deals.”
Stewart’s firm is on the smaller end of the spectrum, focusing on companies in the Upper Midwest with revenues of $10 million to $50 million. The money he invests comes from high net worth individuals and families in the region.
A lot of money comes from families who started businesses in the years soon after World War II and have recently sold them. Private equity firms play both ends of that game, Stewart said, buying the companies from the families and then helping them invest the proceeds in other deals.
“We’re looking at one right now where the brother and sister took over the business from their parents,” Stewart said. It’s got $30 million in revenue, and they’ve done a great job with it. Their kids are all in law school, and none of them have an interest in coming into that business.
“That doesn’t mean they don’t have an interest in the money tied up in the business,” Stewart said. “We’re working on giving them the cash they want.”
Leveraged buyout specialists like him are different from the vilified corporate raiders of the 1980s, Stewart said.
Those people were looking at balance sheets for under-valued assets, he said. They usually had a short-term plan to break up the company and get their money back. Today’s private equity investors want to “buy, build and sell,” Stewart said, but they are in no hurry. A typical timeline might be anywhere from three to seven years or even longer.
“What we’re really good at is looking at building the business. It could be in a week or 15 years but we’re not that good at saying when it will happen. The way we’re structured, we can stay in a company as long as we feel it makes sense.”
Low interest rates
Facilitating the deals for buyout firms today are relatively low interest rates offered by lenders that have been tripping over themselves to do deals.
“There’s so much liquidity out there that the credit markets are subsidizing the purchase prices on these things,” said one Chicago-based private equity executive. “Money is available with relaxed covenants and maturities and low interest. There’s no end in sight,” as long as interest rates remain relatively low and the economy doesn’t come to a screeching halt, the executive said.
A stock market that has reached record highs is also helping private equity. If the stock market is doing well, then investors might have an extra billion sitting in their portfolios to play with and they might put some of it into private equity.
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schandler@tribune.com
