Michael Gross, a founding partner of the private equity firm Apollo Management LP who is now at a hedge fund, recently asked a group of business students at Northwestern University this question: In three years' time, what might the private equity and airline industries have in common? His answer: From day one, neither will have ever made a return for its investors.

It's hard to imagine another industry that has suffered quite the unmasking that private equity has. Hedge funds underwent a calamity, but their basic business of buying and selling stock still works in a leaner world. The business of providing investment advice and making trades-the meat and potatoes of investment banking-will exist even if no independent investment bank does.

But private equity firms are another matter. Once, they purported to be in the business of buying troubled companies and turning them around. They contended that they could manage the companies better away from the public glare of shareholders. That pretense was dropped during the boom earlier this decade. When private equity shops took over companies like the Texas utility TXU Corp. or the casino operator Harrah's Entertainment Inc., which was bought by Apollo, it was clear that these were thriving enterprises, not troubled at all. The private equity firms were simply engaged in "financial engineering," a then-admiring euphemism for a simple conceit: loading up fine companies with massive amounts of debt in the hopes of flipping them to new owners at some point down the road.

When money was loose and leverage was king, private equity firms thrived. No more. In the wreckage of the bust, they have been revealed as hapless corporate stewards and gullible investors. The competition for the highest-profile debacle is stiff. Cerberus Capital Management hasn't been able to manage Chrysler LLC or GMAC LLC. The private equity firm TPG leaped into buying a stake in Washington Mutual far too early and saw its investment wiped out. Stephen Schwarzman took his company public only to see its stock collapse. Apollo has faced one disaster after another. It lost money on Linens 'n Things when the retailer went bankrupt, and Harrah's is struggling. Apollo's Realogy Corp., a real estate brokerage that controls Century 21 and Coldwell Banker, is in the ICU. And Apollo has been knee-deep in litigation with chemical maker Huntsman Corp. and Carl Icahn.

Add to that the reality that private equity firms generally don't make their money by choosing good investments. They make it on an amazing Technicolor array of fees: management fees, deal completion fees, consulting fees, performance fees, special events fees, fees of every kind and stripe. Chalk it up to yet another racket of the
bubble years.

So it would be natural to assume that private equity is in trouble. Yet, in one of the richer ironies of the Great Recession, private equity firms are poised to flourish. They've raised money for new funds and locked it in before investors have had a chance to fully realize how disappointing the returns will be on the last ones. Capital is king now, and many private equity firms have enough money for 10 years.

The private equity industry is shaping up to be a great example of why it can be rewarding to do irrational things in a bubble.

Finding the Suckers
For years, the academic research has revealed private equity's pretense: After fees, private equity firms as a whole don't beat the market. University of Chicago scholar Steven Kaplan studied the industry's returns and in a 2005 paper reported that over a period of about three decades, the average private equity firm's annual return was no better than that of Standard & Poor's 500-stock index. Since then, he has asserted that private equity returns often appear inflated because of some flaws in the way in which they are compared with the broader market. Kaplan points out, for example, that Blackstone Group LP's annual 26 percent return from 2002 through 2006 looked heroic against the S&P 500's 6 percent. But if you lop just a year off the comparison and use Blackstone's performance from 2003 through 2006, the results look much less impressive because the S&P returned 20 percent annually during those years.

More recently, a pair of European academics, Ludovic Phalippou and Oliver Gottschlag, demonstrated in a paper that the poor performance of private equity firms could be understated. When private equity firms report the value of their funds, they include estimated values of deals before the investments are actually realized through a sale or share offering. Surprise, surprise: Those estimates tend to be biased upward. When the data is cleaned up, Phalippou and Gottschlag found, it becomes clear that the private equity industry tended to underperform the S&P 500 by three percentage points a year after fees.

In the end, the data is all largely irrelevant. Private equity thrived-and will continue to thrive-because its execs have excelled at finding believers. Private equity firms long ago persuaded pension funds and endowments to commit to their funds; by 2006 and 2007, they were snowing the banks, which fell over themselves to lend money on questionable terms. Much of this was known at the time and reported in broad strokes. But it's only now becoming clear how masterfully the private equity firms handled those negotiations. Investors poring over beaten-up bonds of private-equity-owned companies currently in trouble are now discovering trip wires galore.

Private equity execs were adept at more than just relaxing the covenants of their companies; they also were brilliantly elastic in defining how profitable their companies were. Take Apollo and its absurd investment in Realogy, which Apollo acquired in December 2006, for a fat premium over the stock price. In a standard loan agreement, the lender gains power and might even assume control if the borrower triggers certain clauses of the contract. Typically, the borrower is required to keep up a certain level of cash flow.

The Realogy credit agreement is a cunning thing of beauty to behold. For one, it has an "equity cure" provision, which stipulates that if Realogy starts running into problems, it can raise money from investors, including Apollo, and then count that money as cash flow for the purposes of its loan covenants. Neat trick No. 2 is that the agreement allows Realogy to take its trailing cash-flow figure and adjust it for the cost savings the company intends to reap if it has merely identified them. That's sort of like asking your mother for your allowance today based on all the chores you plan to finish over the next year.

Such slick terms won't be enough to save Realogy, whose bond prices now reflect the expectation that it is headed toward bankruptcy. The terms were primarily for the benefit of Apollo, which will be able to retain control of its investments much longer than it would have under normal lending conditions.

Siren Song
The other major factor working in private equity's favor is that many of the biggest firms have raised money for their follow-on funds-often before the current fund results that contain the 2006-07 time bombs are fully known. Throughout last year, private equity firms asked their investors to make good on those commitments. Many universities and pension funds began to redeem from hedge funds to fulfill their obligations.

Even though these limited-partner investors in private equity firms are generally sour about the funds' current terrible performance, they don't �really have anywhere to go. Pension funds, in particular, overpromised to their pensioners and are now so desperate for returns, they are going to buy into the private equity story. The academic research shows that the top-�performing funds are more likely to continue to perform well. Therefore, if you can somehow get into a great fund, the thinking is that over time, you'll be in good shape.

"Anyone who goes into private equity thinking the average of private equity will beat the average of the public markets is misguided," says Britt Harris, chief investment officer of the Teacher Retirement System of Texas. "It's well-known that as a whole, it's not a value-added operation." But he latches onto the academic research that finds that the top funds will most likely remain the best performers. "If in first quartile," he says, "outperformance is likely to be very high."

That belief leads to his forgiving mood: "Obviously, we will pay a little bit closer attention," he says of his fund's private equity investments. But when we talked about the terrible time Apollo was having, he said, "Their bread and butter is really dislocated markets like we are in now. The story will unfold over time, but I'm not going to lose a lot of sleep over Apollo." Nor, it seems, are most investors. Despite its multiple calamities, Apollo managed to raise almost $15 billion by December for its next fund.

They should be more wary. The returns of the top performers are unlikely to hold up. The best-performing funds were the ones that dived headlong into the bubble investments. A full 37 percent of the money committed to private equity since 1980 was pledged in 2006 and 2007. That suggests that in a few years, those top performers won't stay on their perch. "My guess is that the megafunds will have lower returns than the smaller funds," says the University of Chicago's Kaplan. "Given that the megafunds had performed well in the past, that would mean that persistence will not occur. Historically, size is the enemy of persistence."

I expect pension funds and endowments will just ignore that prospect and keep giving money to private equity firms anyway. Tony James, Blackstone's chief operating officer, says, "Our limited partners tell me private equity is the single best performing asset class by a lot, but there are parts of cycles that don't look great. Now there are great opportunities that don't require much debt." He adds, "It's one of the greatest times in history to invest money."

That is why the industry won't see further shakeout. Not that things will be rosy by any means. The private equity industry cannot lever up its investments nearly as aggressively as it used to, because banks are no longer willing to lend to them. (Private equity companies hope to compensate by buying businesses so cheaply that they can still make adequate returns.) Dealing with the disasters of 2006 and 2007 will require an enormous amount of time and resources, which will drain capital for new investments. And few private equity firms have adequate skills when it comes to distressed investing, despite the fact that they have raised money to invest in those very situations.

Furthermore, while these firms believe they have raised the money for their follow-on funds, their desperate investors are starting to resist. By the end of last year, TPG and the British firm Permira were letting their investors out of capital commitments, a sign that the leverage of the private equity firms may be ebbing. So the new funds will most likely be much smaller, meaning private equity as an industry will be less lucrative.

Despite all of that, when markets and the economy go south, some investment opportunities become more attractive. Fed-up investors hold on to the hope (which in some cases becomes reality) that the private equity firms will be able to make superior investments in this "vintage," as the jargony industry term has it. Even sophisticated investors who know that the game is rigged think the time is right. I spoke to one former private equity professional who now sits on the other side, at a family office, making investments. "I see no consequences" for the private equity firms from having made all those stupid investments in the bubble years, he told me.

His own experience bears that out. He had investments in a private equity fund of funds that had committed to a TPG fund that had invested in Washington Mutual. The $20 billion TPG fund had put 2.5 percent into WaMu, a disaster, and was offering investors a chance to reduce their capital commitments, but only by 10 percent. His family office's direct exposure to the WaMu failure was paltry. Given that 95 percent of the fund's capital is left to be invested in what he is convinced will be a good vintage, he says, "I'm psyched to be in it. I'm going to double my money. You have an element of robbery, and there are never consequences, but people are happy to be in the next fund."

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