The Money Behind the Private Equity Boom

Low-profile pension funds are funding the historic buyout wave, to pay for the retirement of teachers and other government workers

by Steve Rosenbush

It isn't even Thanksgiving yet, but private-equity funds already have raised more money than they did in the record-breaking year of 2000. U.S. private-equity firms have raised $177.89 billion so far this year, exceeding the $177.75 billion record of 2000, industry newsletter Dow Jones Private Equity Analyst announced Nov. 3. And fund-raising could end the year at $225 billion, far exceeding the $159 billion raised in all of 2005, the newsletter said.

Ever larger deals are announced regularly, all evidence of a historic boom. HCA, the hospital company, went private this year, in a deal that broke the private-equity buyout record set by KKR's RJR Nabisco takeover in 1988 (see BusinessWeek.com, 9/12/06, "Bidding on Freescale Sets Off Alarms"). Even Bill Gates is getting in on the action: His Cascade investment arm teamed up with Saudi Prince Alwaleed in a $3.7 billion buyout offer for hotel giant Four Seasons (FS) (see BusinessWeek.com, 11/7/06, "Barring the Door at the Four Seasons").

Where's all that money coming from? Even Gates and Alwaleed aren't rich enough to fund all these deals on their own. They need help from investors, known in the industry as limited partners. It's the partners, which include some of the world's largest and most powerful pension funds, that are funding the unprecedented boom in private equity (see BusinessWeek.com, 10/6/06, "Institutional Investors Pouring Cash into Private Equity").

Pension Players

In some cases, these pension funds are making private-equity investments of their own, just as any other buyout fund would. "We've been leaders in private equity since we entered the field 10 years ago. We're there for the return," said Jim Leach, who runs the $6 billion private-equity fund at the Ontario Teachers Pension Plan.

Private equity has been a great investment for OTPP. By owning brands such as Samsonite and the Toronto Maple Leafs, OTPP has achieved private-equity returns of 26% a year, easily beating the return in the public market. The fund also invests in other funds, especially in regions or markets where it has little expertise of its own.

That success has encouraged other pension funds to step up their private-equity activity. The New Jersey Investment Dept. is boosting its private-equity allocation to $4.1 billion for the fiscal year ending June 30, 2007. That's up from $2.2 billion in the fiscal year ended June 30, 2006, according to spokesman Thomas Vince. The California Public Employees' Retirement System, the $220 billion California pension plan, invests 6% of its assets in private equity. That's up from less than 1% at the inception of the program in 1990, according to spokesman Clark McKinley. It has $33 billion in private-equity capital commitments and $12 billion in investments. The private-equity investments have returned more than 18%, McKinley says.

Cashing Out

While pension funds and institutional investors have invested in private equity since the industry was created more than 30 years ago, their interest in the sector has soared during the past year. That's because 2005 was a pivotal year for private equity, which cashed out of well over $100 billion in investments and returned loads of cash to investors, according to John O'Neill, partner with Ernst & Young Transaction Advisory Services.

"It all came together in 2005, and every megafund cashed out of its investment portfolio and distributed cash to limited partners," O'Neill says. That was possible because the companies that private-equity firms had acquired several years before were doing well, and it was easy to sell them or take them public. In many cases, pension funds used the profits taken in 2005, and reinvested them in private equity in 2006.