Walk away alive

Private equity wipeouts: Private equity wipeouts are coming thick and fast. The imminent bankruptcy of Reader’s Digest will evaporate the $585 million invested by Ripplewood Holdings and its partners in the magazine publisher. Hollywood studio Metro-Goldwyn-Mayer just reshuffled its management amid concerns it could be the next big buyout in the queue for a Chapter 11 filing.

Private equity investors certainly don’t like to see their cash disappear. But even deals that go pear-shaped may not entirely kill overall returns so long as fund managers avoid taking concentrated bets. The worry is that in the heyday of the recent boom some buyout barons ignored the lessons of diversification.

Tim Collins, who runs Ripplewood, isn't commenting. But the stake Ripplewood holds directly would amount to more than 15 per cent of its $1.1 billion fund. That means Ripplewood must work extra hard on its other investments to return investors’ money–much less make the 15 per cent annual returns they have come to expect.

Kohlberg Kravis Roberts offers Exhibit A on why diversification makes sense. The private equity firm invested 58 per cent of its 1987 fund in the buyout of RJR Nabisco. However, RJR turned out to be a bit of a dud and consequently the fund eked out a return of just 9 per cent annually.

Most investors in private equity today stipulate how much a fund can plug into a single deal. KKR doesn’t have more than 13 per cent of its 2006 fund in any one company, for example.

Cerberus invested less than 5 per cent of its fund into Chrysler – the rest came directly from some of its investors and allies. While that money was incinerated when the carmaker went bust, the Cerberus fund won't blow up just because of Chrysler.

Of course, Cerberus, for example, also invested in GMAC, the financial arm of General Motors that needed a $13.5 billion infusion from the government. Eschewing concentrated individual bets can soothe the pain of the occasional wipeout. But it's no cure for multiple investment disasters.