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How losses of private equity firms impact on big institutional investors

source: wsj

Big investors like pension funds and endowments, licking their wounds from miserable returns last year, are bracing for more.

In the next few weeks, private-equity firms — which buy companies, take them private, restructure and resell them — will report declines of 15% to 50% for the fourth quarter of 2008 amid the deep economic recession, analysts and investors say. Two big private-equity firms already have reported sizable declines in the value of their hard-to-price holdings.

Those drops in turn will further batter the performance of public pension funds, foundations and endowments. These institutional investors had barreled into private-equity investing in the past decade, hungry for market-beating returns. Some hold 10% or more of their assets in these private-equity firms.

The valuation of assets by financial players has been central during the financial crisis, with banks and securities firms taking hundreds of billions of write-downs in assets. Markdowns at private-equity firms have lagged behind those of banks and are now coming into play because of new accounting rules that require private-equity firms to mark their holdings at prices at which they could sell them in the current market.

"The [private-equity] values being carried by pension funds have been twice what they should be," says Donald Putnam of Grail Partners, an investment-advisory firm, referring to their private-equity holdings.

A sign of the damage came in recent earnings releases from private-equity firms Blackstone Group LP and Kohlberg Kravis Roberts & Co. Blackstone wrote down its equity holdings by 20% and its real-estate holdings by 30% for the fourth quarter. KKR said its publicly traded unit fell 32% in the quarter, trailing the average decline of 23% for the Standard & Poor's 500-stock index.

It could get uglier. On Wednesday, in a sign of the dire outlook for highly indebted companies like those in private-equity firms' portfolios, Moody's Investors Service put about $100 billion in notes backed by risky corporate loans on review for ratings downgrades.

Making matters worse for public pension funds and others: Many had funded budgets partly from distributions of cash by private-equity firms as they realized profits on the companies they bought and restructured. Those distributions have stopped.

The result is that many foundations and other investors remain strapped for cash, while others are raising the level of their cash reserves to be safe. Ellen Shuman, chief investment officer of the Carnegie Corp. of New York, says her $2.6 billion foundation, with about 17% in private equity, is holding up to 7% of assets in cash, compared with as little as 1% normally.

Meantime, funds, endowments and other big investors had agreed, under prior arrangements, to continue to fork over new money to private-equity firms for additional investments.

Now, some investors are fighting back. "We've told our partners: 'Don't you dare draw down more cash unless you have an investment transaction to do,'" says Christopher Ailman, chief investment officer at the California State Teachers' Retirement System, which has about 14% of its $120 billion in private equity, up from 5% in 1998.

The fund's more than 100 partners, including Carlyle Group and TPG, have listened and such "capital calls" have slowed, Calstrs says.

Private equity will be a drain on cash "throughout 2009 and probably at least in early 2010, if not for all of next year," says Ronald Schmitz, chief investment officer of the Oregon Public Employees Retirement Fund. With about 22% of the fund's $45 billion in assets already in private equity, Mr. Schmitz says the fund plans to scale back on commitments to any new private-equity funds this year.

Despite the large write-downs from Blackstone and KKR, some industry specialists believe fourth-quarter markdowns are unlikely to reflect the full extent of declines in value. "In some funds there is denial going on" about the extent of write-downs needed, says David de Weese, who heads secondary-market trading at Paul Capital, which invests in private-equity funds on behalf of clients.

Paul Capital believes that institutional investors could put as much as $130 billion to $140 billion in private-equity investments, including unfunded commitments, on the block over the next two years. With demand at less than $15 billion on the secondary market to buy these assets, Mr. de Weese says deals that are being done are at "steep discounts" of between 30% and 70%, underscoring the uncertainty surrounding private-equity asset valuations.

Harvard Management Co., which manages the largest college endowment, attempted last year to unload private-equity investments valued at about $1.5 billion. But the endowment was unsuccessful, receiving bids only for certain partnerships.

Endowment officials balked after receiving bids for 50 cents on the dollar or less. More recently, Harvard has broken up the investments into smaller blocks and is remarketing them, according to people familiar with the matter. A Harvard spokesman declined to comment.

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