U.S. buyout firm Kohlberg Kravis Roberts & Co. had little trouble this week finding buyers for shares of a new fund that lets smaller investors participate in private equity.
But while the popularity of private equity IPOs could grow after KKR's $5 billion blowout offering, some say investors new to private equity should be careful, given the long-term nature of the investments and the fact the deals are coming as the returns on such funds are expected to drop.
There has been more and more money in the private world chasing fewer deals, and valuations have been bid up, warned Franklin Morton, a senior vice president of portfolio management at Ariel Capital Management in Chicago.
Private equity firms typically buy companies or controlling stakes, restructure the businesses, and sell them -- usually in three to five years -- for a premium. They pay for deals with a small wad of cash and use leverage, or debt, to pay for the rest. The firms keep a slice of the profit they make and give the rest back to their investors -- mostly large institutional entities such as pension funds, banks and endowments.
Another issue for smaller investors is access to information about fund performance.
If you are a large state pension manager who put up several hundred million dollars, they are going to take your call a lot faster than if you are a retail investor that buys a hundred shares, Morton said.
Returns for the top 25 percent of all funds have been huge in recent years -- exceeding 50 percent in several cases -- catching the eye of investors who have poured cash into the funds instead of the equities markets.
KKR's private equity unit made its debut on the Euronext Amsterdam exchange this week in a 200-million-share public offering. The deal was increased in size from the $1.5 billion the firm had initially hoped to raise.
KKR Private Equity Investors
The fund's quick success may spur others to market. The Blackstone Group and the Carlyle Group, two of the largest private equity firms, also are looking closely at their public market options, bankers say.
For now, a marquee name has gotten this into the collective unconscious, making investors more comfortable with the idea, said Edwin Pease, a partner with the law firm of Brown Rudnick in Boston.
Still, private equity is not for the faint of heart. Some say its best returns are behind the industry. The return of corporate buyers, competition within the buyout industry and frothy debt markets have prompted some private equity firms to pay high prices for companies. The more they pay, the less money they can give back to investors.
Historically, buyout firms have generally aimed to pay around five times a company's cash flow. But in the last year, buyout firms have consistently paid more than eight times cash flow -- in some cases, more than 10 times.
Given the lower returns expected going forward, the timing certainly raises a question, Morton said, speaking of the possibility of funds' selling shares to smaller investors.
Beyond that, private equity investing requires much more patience than owning stocks or bonds. In the private equity world, funds must be invested before returns dribble in several years down the road.
Private equity is a slow business -- don't expect miracles initially, points out Brian Rohman, managing director at Robeco Investment Management.
(Additional reporting by Michael Flaherty)