Buy or sell? Uncertain times in private equity: it's a good time to take profits, if you bought low. But firms that came in at high prices face a shakeout.

Pension funds and the super-rich took a walk on the wild side in 1999 and 2000, pouting hundreds of billions of dollars into private equity funds.

Much of that money went poof--invested in fanciful ideas like optical switching technology and telecommunications, and purchased at the top of the market. By the time the cheap deals came along, many of the funds were already depleted from previous mistakes.

Now, with the rise of the stock market in the past year, private equity is making a comeback--but not for everyone.

Though deal prices are rising, big investors have pared their appetite for risky funds, leading to speculation that some firms will not survive.

"The conventional wisdom is that there probably will be a shakeout and some funds will be out of money and just hanging in there," said Robert Bergmann, managing director of Centre Partners Management LLC. He opened a Los Angeles office for the New York-based firm three years ago; it counts Johnny Rockets and Buca di Beppo restaurants in its portfolio.

A similar dynamic occurred with venture capital funds a couple of years earlier.

Since peaking in 2000 at $100.7 billion, the amount of money raised by private equity funds has fallen by nearly 30 percent a year, to $36 billion in 2003.

Most vulnerable to a shakeout are smaller funds and ones that were established in the vintage years of 1998, 1999 and 2000. The data is lacking, but funds that got started during these years appear to have thrown off the most wretched returns. (Private equity firms don't have to publish their results, although there is some pressure for more disclosure.)

The fallout may be a silent one, though, because when firms close their doors they don't really fold, they simply stop investing.

Typically, private equity firms target underperforming private companies that need capital infusion and sometimes a management makeover. Then they try to reposition them for growth.

Centre Partners, for example, completed a carve-out last year of San Diego's Bumble Bee Seafoods, formerly part of ConAgra, for roughly $200 million.

The companies are then bundled into a fund that is expected to generate returns of 25 percent to 40 percent or more, outpacing the stock market. "We look at a lot of private companies that have a niche--they're slow-growth, the family makes a lot of money and they have 150 employees," said Michael Fourticq Sr., managing partner of Hancock Park Associates in Century City. The firm typically invests $5 million to $10 million in private companies and takes operating control. "When we're done with a company," he said, "they have 600 employees and have become growth engines."

Huge public institutions, such as the California Public Employees' Retirement System and the University of California endowments, invest heavily in private equity funds. Many of them are in Los Angeles, where the concentration of family- owned businesses creates lots of possibilities.

Some of the largest local private equity firms include Ares Management, Canyon Cap ital Advisors, Freeman Spogli & Co. and Leonard Green & Partners. Many of the financiers who run these funds trace their roots to Michael Milken's old firm, Drexel Burnham Lambert, the creator of the junk bond.

Nationally, Blackstone Group and Apollo Management LP, both of New York, and TPG Ventures, an affiliate of Texas Pacific Group, each has billions under management in various funds.

Last month, L.A.-based Freeman Spogli sold a 25 percent stake in Pantry Inc., a Sanford, N.C., convenience store chain, for $100 million, leaving it with a 42 percent ownership interest. The stock has risen nearly 11-fold in just over a year, a remarkable turnaround. Freeman Spogli has been an investor since 1995, four years before the company went public.

Rising allocations

Some believe the rising stock market will force pensions and endowments to allocate more money to their private equity commitments. Pension funds typically target anywhere from 8 percent to 30 percent of their portfolios to private equity, and with stock markets on the rise for the past year, some assets may need to be shifted away from equities.

Even with the decline in private equity investment, inflows haven't fallen as far as they did in public markets: private equity has been rising as a percentage of all investments for the better part of a decade.

At the end of 2003, about $700 billion was under management at 2,600 U.S. private equity firms, according to Thomson Financial. While investments into the funds have slowed, the dealmaking by the funds themselves has increased. Private funds accounted for 13 percent of all merger and acquisition activity last year, a 41 percent increase, according to data provider Dealogic.

With more money chasing higher returns, larger firms are bidding up prices. The cost of buying private middle-market companies has skyrocketed, though smaller companies appear to be more reasonably priced, Fourticq said.

Banks, too, have fed into the price rise. With interest rates at historic lows and debt still cheap, banks that had been reluctant to lend too much are now competing for a piece of the action, by offering to lend a higher percentage of each deal.

In a sign that companies are using more leverage, Brentwood Associates in December completed an unusual dividend refinancing of Oriental Trading Co., an Omaha, Neb. direct marketer that it bought in 2000.

Fourticq differentiates private equity firms from the leveraged buyouts of the 1980s, which he calls "financial mechanics."

The process of buying and selling companies and investing in small businesses is about "adding value" to a company. Usually that is accomplished by putting into place an experienced management team, giving a capital infusion that often involves buying up similar businesses and combining them, and returning to profitability.

"Sure we make big money," he said. "But that's the system. We take big risks and at the end of the day, we're creating jobs. We've easily doubled the employment at the companies we've acquired."

Valuation equation

Even so, failed investments have caused some private equity firms to mimic the failures of venture capital firms in the late 1990s.

Without public disclosure, there is no way of knowing if portfolio companies are profitable, if bad apples are hidden within a portfolio, or if profits are held down for tax reasons.

"I think general partners are covering up the problems in valuations because it's going to affect their internal rate-of-return records," said Darryi Laws, managing general partner of the Caledonian Private Equity Fund in La Jolla, an affiliate of merchant bank Charlotte Square Capital Ventures. "So they're not in a hurry to exit existing portfolios and instead are raising more money in the hopes that by bundling, they will get a combined yield."

Because there is virtually no public information about private equity firms, pension funds have come under pressure to disclose information about their investments.

In 2002, a California judge ordered Calpers, the largest private equity investor, with $20 billion invested, to disclose how much it has earned or lost in private equity funds after it was sued by the San Jose Mercury News under the Freedom of Information Act.

Since then, Calpers has disclosed individual rates of return for its funds, but a San Francisco Superior Court judge upheld the privacy of individual companies within a portfolio claiming they were "trade secrets."

The fear is that with borrowing easier, private equity firms are too much for portfolio companies.

"The prices that some people have been paying simply are not justifiable unless their limited partners expect lesser returns," said Marty Jelenko, managing partner at Century Park Capital Partners in Century City.

Some companies are being sold at prices of between four to seven times EBITDA, or earnings before interest, taxes, depreciation and amortization. Those levels were last seen in 2000.

With competition tougher, some smaller firms have begun to stratify into niches.

Robert Forbes, a former design engineer at Ford Motor Co. who now runs Glenmount International, a small private equity firm in Irvine, describes his firm as a "farm team" focused solely on investing in industrial technology and automation.

Glenmount puts a substantial portion of money in a single company, working with existing managers on automating processes and streamlining the supply and distribution operation.

"Everybody is saying everything is being moved to China," he said. "But it doesn't need to be."

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