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Opportunity Plus Risk for Private Equity Funds

February, 2004

STANFORD GRADUATE SCHOOL OF BUSINESS—Private equity partnerships face rocky returns in the next few years, as high prices paid for companies in times of "excessive expectations and unrealistic valuations" work their way through the system, Carl D. Thoma, MBA '73, told the Stanford Business School's Principal Investment Conference on February 18.

The managing partner of Thoma Cressey Equity Partners and a keynote speaker at the student-sponsored conference, Thoma surveyed 30 years of middle-market investing—defined as the private market for companies valued at less than $300 million. He and his partners have invested over $2 billion raised in seven private investment funds. To date, these funds have provided a 25 percent annual compound return to their investors, he said. "Yes, it was a little higher until the last few years," Thoma added.

Buying and reworking companies, then selling them—once known as "consolidations" and now called "buy-and-build"—began in the 1970s as something of a Wild West ride, Thoma recalled. "The business was very entrepreneurial," and, as pension funds hadn't yet entered the private investment market, high-risk money was scarce. There was little competition for attractive deals. "In the 1970s, if you had money, you made money," Thoma said.

Today, partnerships often overpay on their initial purchase under the pressure of billions of investment dollars that have flowed into the market, Thoma said. Some 60 percent of all money ever invested in private equity poured in between 1999 and 2001. Much of this money faces an unhappy end. "The 1994 vintage year [of investment partnerships] is the last year for which buyout funds have returned all the money to limited partners," Thoma said. "So we're basically facing a period where returns are not going to be good," he added. The past two years, he said, "produced exceptional returns. I'm worried that we could get overconfident and spend some of our recent strong performance gains on overpriced deals."

Companies that are "buy-and-build" candidates are selling for 10 times earnings and higher, Thoma said, compared with past private equity ratios of six or seven times earnings. And more players are seeking more deals. Over 13,500 professionals now crowd the private equity business compared with just 500 in 1980, Thoma said.

From the invention of the industry and spectacular returns in the 1970s, middle-market investment swung to the junk-financed leveraged buyouts of the 1980s and then to the 1990s obsession with technology companies and unrealistic valuations. "Each decade has had its own unsustainable experience," Thoma noted.

Even so, common themes stretch through middle-market buy-and-builds, Thoma said. Patient money is needed. Three-to-five-year investments are the rule. The business is one of detail, of constant attention and knowing industries inside-out, of strategy and timing. Fast flips don't work. "If you want to do transactions, become an investment banker," Thoma advised.

He predicted that hedge funds will become a real competitor to private equity for investment capital, given performance and liquidity. "We are both the same asset class—alternative investments," Thoma said.

—Fred Rose