Even as the debt crunch is putting deals on hold, long-term investors are still flocking to buyout funds.

By Grace Wong, CNNMoney.com staff writer

LONDON (CNNMoney.com) — Amid the freeze on private equity deals, big investors like pension funds and college endowments are still plowing money into buyout funds, suggesting they still see opportunities for outsized returns.

Buyout funds have already raised $139 billion globally so far this year and are on pace to exceed the $212 billion raised in 2006, according to London-based research house Private Equity Intelligence.

Tim Hughes of the IG Index joins CNN to talk about the U.S. market’s impact around the world.

Another record year of fundraising comes just as the buyout boom has come to a grinding halt. A push back in the debt markets that began in late June has erupted into a full-blown credit crunch, with financing for leveraged buyouts now at a standstill.

“What will hurt private equity is that it’ll get harder to fund deals going forward. The real question will be whether they can keep generating returns,” said Steven Kaplan, a professor of finance at the University of Chicago’s Graduate School of Business.

Loans for private equity deals have practically dried up. Only halfway into August, monthly loan volume in Europe has trickled to $2.2 billion, down from a high of $58.7 billion in March, according to Thomson Financial. In the U.S., volume has fallen to $23.1 billion this month from as high as $47 billion in March.

The days of cheap credit are over, and private equity firms will have to start forking over more of their own money when they do deals, analysts say. On top of that, they’ll have to pay higher borrowing costs, which could end up eating into their returns.

“Private equity companies are likely to find the higher interest-rate environment more challenging after using cheap financing to make acquisitions,” ABN Amro portfolio manager Patrick Lemmens wrote in a note this week.

But Lemmens isn’t an outright pessimist. “These have been heady days with phenomenal returns, and while returns are likely to come down somewhat, they should stay strong.”

And while the deal climate may be tougher, there are still opportunities. “Lack of leverage in the marketplace should make prices more attractive. For people buying companies in the near future, prices will come down,” boosting potential returns, said Lou Moelchert, founder and managing partner of Private Advisors, a global alternative investments firm.

The big, mega deals that have characterized the recent buyout boom are the ones most susceptible to the debt crunch, Moelchert said. These deals may also be the most disappointing to investors, since top prices were paid during the peak of the boom.

The confidence of institutional investors who give money to private equity funds, known as limited partners, doesn’t appear to have been shaken so far. Fundraising remains strong, especially among the firms with the best reputations. Private equity powerhouse Blackstone Group recently closed the world’s largest private equity fund at $21.7 billion and has said it’s already gearing up to raise its next fund.

Limited partners have a long-term investment horizon, committing money for up to 10 years in some cases, so the recent challenges facing the market aren’t likely to rattle them too much, according to Mark O’Hare, managing director of Private Equity Intelligence.

O’Hare thinks Blackstone’s record-sized fund could be eclipsed soon. “The record flows of money into private equity funds don’t represent a cyclical peak but rather a very powerful long-term trend of significant growth. Private equity has proven to be an effective and successful ownership model for the right sorts of assets,” he said.

That may be true, but whether private equity funds end up delivering the double-digit returns investors seek will in part depend on whether the credit crisis leads to an economic slowdown. That would pressure the businesses in private equity portfolios and could crimp returns for fund investors.

“Is the economy at risk? How much of this will leak into the real economy? I don’t know if anyone knows the answer. People are betting things are going to be okay, but nobody really knows,” Kaplan said.

Copyright Fund China 2009.

You Might Like: