The 'golden age' of private equity is here - but how long can it last?

<i><b>Business Analysis:</b></i> As Carlyle unveils $10bn buyout fund, increased competition is driving down returns
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America's Carlyle Group announced yesterday it had raised the world's largest ever private equity fund: $10bn (£5.3bn) of new money to spend on undervalued companies in the US and Europe, in the hope they can be transformed into generators of bumper returns.

America's Carlyle Group announced yesterday it had raised the world's largest ever private equity fund: $10bn (£5.3bn) of new money to spend on undervalued companies in the US and Europe, in the hope they can be transformed into generators of bumper returns.

The politically well-connected Carlyle - its senior appointees have included George Bush Senior and Britain's John Major is still an adviser - unveiled the fund raising just a day after SunGard Data Systems also pushed the size limits of the private equity world. The US technology company agreed to sell itself to a consortium of private equity firms for $11bn in the largest buyout since the food group RJR Nabisco fell to Kohlberg Kravis Roberts for $30bn in the 1980s.

Big, it would seem, is very much back in vogue in the highly competitive world of private equity. That raises the possibility that almost any struggling company, no matter how large, is now within the grasp of the titans of the private equity world.

According to Dan Akerson, the head of Carlyle's US buyout business, the market will be consolidated to three or four huge players. "You are going to have to be a mega fund if you want to remain in the top tier," he said. At the other end of the spectrum, small and highly specialised firms could exist, picking up deals which are not deemed to be worth the while of the giants.

While Carlyle can enjoy being top of the tree for a while with the $7.8bn it has raised to invest in the US and $2.2bn to inject into opportunities in Europe, it will not be long before competitors catch up. Funds being raised by Blackstone Group, Goldman Sachs's private equity arm, and New York-based Warburg Pincus are expected to match or to be even larger than Carlyle's war chest.

Chris Davison, the associate director of the research house Almeida Capital, said: "A lot more money is flowing into private equity than has done for a long time - arguably than has ever been directed into it. So private equity has the ability to target larger assets than it ever has before."

It is not difficult to see why private equity has attracted such large amounts of investment. While stock markets have slumped over the past decade, recovering only to a pattern of modest returns, private equity has regularly returned 30 or 40 per cent to investors. There are now so many players in the market - including hedge funds - that average returns have fallen to about 15 to 20 per cent, but they are still much healthier than other asset classes.

As a consequence of their sustained success, investment banks have handed over millions of dollars in loans to private equity firms, which has allowed them ever-greater leverage on bids. Leverage allows private equity to turn a pot of $10m into the ability to buy a company for $100m. The idea is then to pay the debt back from the cash flow of the company, while leaving the private equity firm owning the asset. The sector has been successful through a mixture of financial engineering - debt is a more tax efficient asset class than cash - and through straightforward cost cutting and reorganisation at the company.

Several of the larger private equity firms have also been able to take advantage of the improving sentiment in the stock market to float businesses they have held for several years, thus raising more cash.

In search of more aggressive investment strategies to address the needs of an ageing population, pension funds too are funding private equity.

Daniel D'Aniello, a founding partner of Carlyle, declared recently that private equity is enjoying a "golden age". The company, which now has more than $25bn of assets under management, chooses not to do many deals as part of consortia, preferring to have sole control over management and strategy. It opted out of joining the SunGard deal as the expected return would not be good enough.

But the heady days the sector is experiencing are increasingly expressed by private equity firms joining together to go after ever larger prizes. This month Toys R US agreed to a $6.6bn takeover by a consortium of three private equity firms. And over the Easter weekend, seven private equity partners sat down with five debt providers, advisers and lawyers and signed the deal to take the Pennsylvania-based SunGard private.

The SunGard deal is not just big, it is also highly leveraged. The debt, estimated at more than seven times earnings before interest, tax, depreciation and amortisation, is greater than the previous value of the company. It is also considerably higher than the norm in other recent buyouts of five or six times earnings.

According to Mr Akerson, the willingness of banks to lend this much has made the credit market for private equity "white hot". In turn, that has driven up the price of businesses, because sellers know private equity has access to almost unprecedented levels of cash. The process is now usually conducted through an auction, which also ratchets up the price.

While few are suggesting the top of the private equity market has been reached, its experienced players say the underlying economics of the business are heading for a readjustment.

Mr Akerson said that if interest rates continue to rise, private equity firms would no longer have as easy access to credit. "If the credit market cools, maybe [debt] multiples will come down," he said. That could be good news for the robust buyout firms which avoid the credit crunch, because lower prices should mean a return to better returns.

In the meantime, Mr Akerson acknowledges, private equity firms have some reputational issues to resolve with the general public, associated with the fact that some of his profession like to see themselves as "masters of the universe". But while profits continue to flow in, they might be disinclined to become more humble.