With Poor Returns and Limited Funds, Private Equity Falters as REITs Surge

(August 27, 2009) – It’s been a rough year for private equity. With returns low and regulators clamping down on where private equity firms can invest, institutional investors are looking increasingly looking elsewhere for outsized returns.

First, the poor returns. According to public records, three of the largest American public pension plans — The California Public Employees’ Retirement System, the Washington State Investment Board and the Oregon Public Employees’ Retirement Fund – have taken back just $22.1 billion in cash from buyout funds they invested in since 2000 – a figure that amounts to a 59% shortfall, according to Bloomberg. While the internal rate of return (IRR) figures for private equity funds are often better, these managers are griping over their inability to access their investments.

“I work for over 400,000 employees, and they can’t eat IRRs,” said Gary Bruebaker, the chief investment officer of the Washington State Investment Board, told Bloomberg. “At the end of the day, I care about how much do I give you, and how much money do I get back.”

Then, the regulation. With pressure to regulate any institution that poses systemic risk, private equity has come under the regulators’ microscope. For example, the Federal Deposit Insurance Corporation (FDIC) has been in discussions over whether to enforce a rule that would see any investor holding over 24.9% of a bank’s ownership subject to bank-holding company regulation, which private equity investors clearly would want to avoid.  With many banks headed to the auction block following bankruptcy and seizure by the FDIC, these potential investments – enticing to risk-taking private equity groups – could effectively be off-limits if this rule is enforced.

The result: inflows into private equity funds are down significantly. According to Real Estate Alert, a trade publication, America’s 50 largest public pension plans are likely to commit only $5 billion to real-estate private equity vehicles in 2009, a figure not seen since 2003. By comparison, $36 billion flowed into such investment vehicles in 2007.

So who wins? Recent data show that a likely benefactor of private equity’s troubles are real estate investment trusts (REITs). Capital inflows into these public property companies have been robust in the past year as investors seek to profit from a recovering real estate market. According to data from the Wall Street Journal, REITs have raised nearly $15 billion in new equity in 2009, as well as $2 billion in unsecured debt this month alone. While institutional investors have traditionally gone the route of private equity funds, it is likely that REITs – who took on less debt and thus are more likely to have emerged from the real estate bust in healthier shape, and have easier access to capital – will be among the beneficiaries of private equity’s troubles.