Private money (cont.)

By Rik Kirkland, Fortune

Already this alternative universe controls assets approaching 10% of the value of the companies listed on the New York Stock Exchange. McKinsey (a company for which I do the occasional project) estimates that the industry's Big Four - Blackstone, Carlyle, Texas Pacific Group, and Kohlberg Kravis Roberts - are today among the world's 15 most valuable non-oil private companies. If they were publicly traded, their market caps would range from $60 billion to $80 billion. That vaults them into a league alongside such familiar giants as Morgan Stanley, Apple, and Boeing.

Has private equity peaked?

A mounting number of signs suggest that the top is in sight: frantic levels of fundraising, ever-rising premiums, the frenzy among novices to get a piece of the action through new publicly traded buyout funds and got-to-have-'em IPOs such as Fortress Investment Group's. This alternative-investment boutique run by Goldman and BlackRock vets became the first hedge fund to trade on the NYSE on Feb. 9, delivering nearly $10 billion in value to its five principals within hours of the opening bell.

One way to call the top is to look at where newly minted MBAs are headed. The best candidates are as excited about private equity today as many of their predecessors were about becoming venture capitalists in Silicon Valley a decade ago. Today's PE novices are drawn by first-year compensation that can hit $1.2 million with deferred bonuses (more than double the annual dough previous "it" jobs at hedge funds offered) - and by something else. "People just see it as more fun - that sense of ownership private equity offers vs. merely providing a service in traditional consulting or investment banking," says Philip Delves Broughton, a 2006 HBS grad.

Another cloud on private equity's horizon is pushback from the government and from public-company directors who are upset over the notion that corporate America has been selling itself too cheaply. A special board committee at Cablevision recently rejected the Dolan family's bid to take it private. Similarly, a number of normally mute institutional investors, including that trillion-dollar gorilla, Fidelity, are now leading a fight to reject the Mays family's $26 billion buyout of Clear Channel Communications.

GE's (Charts) Jeffrey Immelt, who's shopping around his plastics division for $10 billion and change, is pushing back too. He insisted last month that buyout firms could not band together to bid, an implicit acknowledgment that such "club deals," as they are known, are anticompetitive. (For several months now the Justice Department's antitrust division has been studying these instances where several firms bid together rather than against one another. But if any action is forthcoming, most observers believe it would likely be civil, not criminal: an old-fashioned restraint-of-trade case reminiscent of when the airlines were called on the carpet for price-fixing.) No wonder the leading private-equity firms are setting up their first lobbying groups in Washington and London.

But what about the returns?

Private equity owes much of its reputation among investors to a variation on the "Lake Woebegon effect": Read the funds' prospectuses, and you might think this is a world where everyone is above average. The truth is, if you could have purchased an index of all private-equity funds, you'd be living in a world of hurt.

In his 2005 book, Unconventional Success, David Swensen, whose 22-year stint managing Yale's endowment fund has established him as one of the world's best investors, put it this way: "The large majority of buyout funds fail to add sufficient value to overcome a grossly unreasonable fee structure." Swensen also notes that merely adding comparable leverage to the S&P 500 delivers returns that beat the buyout boys like a rented mule. Study after study confirms his finding.

McKinsey recently analyzed the results of 106 mid-market funds and 57 large-cap funds raised in the U.S. between 1995 and 2001, and matched them against comparably timed public-market investments. The showing of the top quartile of PE funds is indeed stellar: They handily outperformed, delivering average annual gains of 23% and 17%, respectively, with the best coming in as high as 57% and 28% - far ahead of the 11.5% and 5% returns of the public indexes. The shocker is that more than half of these funds came in well under the indexes, sometimes as much as 20% or more below.

Surveying a larger group of funds over a longer period - from 1980 to 2001 - Steve Kaplan of the University of Chicago and Antoinette Schoar of MIT found that while the average fund just beat the S&P 500, it trailed slightly after accounting for the private-equity man's cut. Nor is it a good sign that so many deals are being done at this well-advanced moment in the business cycle.

"Historically, the highest returns in the buyout business have come from investments that were made during a recession or in the early stages of economic recovery," points out George Siguler, managing director of Siguler Guff, a thriving niche PE firm with $3.5 billion under management.

Is private equity good or evil?

A fair yardstick for measuring the success of a private-equity firm's management skill is: Does it leave a company operationally better than it found it? The best evidence that's happening is a recent study by Josh Lerner of the Harvard Business School and Jerry Cao of Boston College.

Examining the post-IPO track records of nearly 500 LBO companies brought back to the public market by PE firms between 1980 and 2002, they found their value rose faster on average than both the overall indexes and the shares of new firms not backed by private equity. "Right through 2005, the central tendency we found paints quite a pretty picture," says Lerner.

In addition, Lerner and Cao's study found an intriguing stat for the average stock picker: The companies private-equity firms bring to market after owning them for a year or less underperform the market by 5% over the next three years, but those they hold for three or more years outperform by 18%.

"Our model is really best in those periods of a company's life cycle where transformation is critical," explains Donald Gogel, CEO of Clayton Dubilier & Rice, which fashions itself as a "craft" PE shop that concentrates on only two or three big deals a year. "Our edge comes when changes are required that disrupt the smooth earnings-growth trajectory expected of public companies."

Even changes dismissed as clever financial engineering, Gogel argues, may often be founded on nitty-gritty expertise. His firm studied both Hertz and the securitized debt market for more than three years, he says, before concluding that "we could push the boundaries of how much a rental fleet could be securitized by many billions of dollars." And so they did.