Is private equity a good investment?

Is private equity a good investment? At this stage, it seems unlikely: the "golden years" for private equity are "in the past", says Jenny Anderson in the International Herald Tribune. The sector has boomed in recent years thanks to low interest rates and a flood of global liquidity. The value of global buyouts jumped from $250bn in 2005 to $450bn last year as the industry raised a record $404bn; February's $45bn acquisition of Texan utility TXU also set a new record.

Now the easy money has been made, but private-equity firms "have more money than ever to spend and are under more pressure than ever to perform", say Jon Ashworth and Allister Heath in The Business. That means many are taking on more risk or overpaying. The gearing ratio used to buy firms has risen from around four times operating profit to seven times. Fortune's Jon Birger points to the "silly" 25% premium paid by Blackstone which is now set to cash in on private-equity fever by going public for an "already-overpriced" Equity Office Properties, which cost it $39bn.

Carlyle Group's co-founder, Bill Conway, has warned that the cheap liquidity fuelling the extravaganza can't last. The head of Blackstone himself, Stephen Schwartzman, alluded to the problem that buyout firms had more money than they could sensibly invest a year ago, saying that "one of the signs [of trouble ahead] is when dummies can get money and that's where we are now". So with the boom in danger of becoming a bubble and vulnerable to a turn in the economic cycle, say Ashworth and Heath, returns are henceforth unlikely to be spectacular.

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Not that historic returns have been all that great. The University of Chicago's Steven Kaplan and Antoinette Schoar of MIT found that the average private-equity fund (net of fees) roughly equalled the return of the S&P 500 index between 1980 and 2001. John Authers in the FT says that according to the US Venture Capital Association, private-equity returns have marginally beaten those of the S&P 500 over the past five and ten years at 9.2% and 8.8% respectively but have fallen short of the Russell 2000 Value index of small, undervalued firms (14% and 13.3%), which typically fall prey to private equity. Given that funds can boost their returns with leverage, they should "easily beat" the Russell. Other research, factoring in investments that funds have been unable to exit from when they wind up, as well as fees, point to returns below the S&P 500. In Europe, private-equity funds returned an average 10.3% a year, net of fees, in the decade to 2006, compared with an annual 5.5% by the Morgan Stanley Euro Equity index. Then again, the Henderson European Smaller Companies fund has returned almost 16% a year over the past decade, according to Morningstar.com.

Citigroup's Darren Brooks says that over the past ten years investors could have beaten returns on the best private-equity funds by applying private-equity-style leverage to a portfolio of mid-cap stocks. Investors in private-equity funds often have to lock up their capital for seven to ten years if they can get into them; many funds are not available to the public. And they're not cheap: typical annual fees range from 1.5%-2.5% and 20% of profits go to the managers. So given unconvincing historic returns and the exuberance in the sector, we would be inclined to steer clear. But if you're interested in private equity, it may be best to explore investment trusts in the sector, which have on average doubled over the past three years. Justin Modray of Bestinvest highlights Dunedin Enterprise, Graphite Enterprise and HG Capital.