The shrinking private equity world

Private equity funding is drying up as investors have been seeing lackluster returns. And the trend looks likely to continue.

NEW YORK (CNNMoney) -- The notoriously private private equity industry can't escape the glare of the spotlight these days, but the more immediate issue facing the industry is a lack of funding.

In 2011, U.S. firms invested just $32.1 billion in private equity, down nearly 79% from the industry's peak year in 2007.

And 2012 is expected to be even worse.

"It's taking a lot longer to raise funds," said Jeffrey Bunder, head of Ernst & Young's global private equity practice. "The process isn't like it used to be. They're having to demonstrate why they deserve the money."

Pensions and endowments, which make up the bulk of private equity investors, have been casting a wary eye on the industry because of the combination of high fees, lackluster returns and generally erratic returns.

Keith Garrison, the director of alternative assets for Texas Christian University's $1.1 billion endowment, said he's been more cautious about investing in buyout funds since the financial crisis.

"The returns have been more drawn out than you would have originally anticipated," said Garrison. "We need to manage liquidity. I'm not the only endowment closely watching its allocation to private equity."

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Unlike hedge funds or other assets that offer quarterly returns, private equity funds return cash to investors only when the companies they're invested in are sold, go public or add new debt.

Part of the problem for the industry is that since the financial crisis, private equity firms have had a hard time selling their acquired companies, as mergers and acquisitions and initial public offering activity slowed down.

In fact, current returns are at their worst level since at least 1990, when the California Public Employees' Retirement System first started tracking the data.

Private equity funds raised in 2006 have returned just 4.2% to investors, according to the pension fund's website. Funds raised in prior years generated double digit returns. Similar to hedge funds, managers of private equity firms generally earn 2% fees on all funds they manage and 20% of all profits.

Meanwhile, the same firms are struggling to find companies to take private that could generate returns. The industry is sitting on roughly $400 billion of cash globally. Private equity managers haven't found the right companies to put this so-called dry powder in.

All but the best performing firms are expected to shrink, as investors put a smaller amount of their portfolio into private equity firms.

Firms that have raised between $1 billion and $5 billion with so-so performance will have the most trouble raising new funds.

Most of the largest funds that already have a spot in a public pension such as CALPERs, which manages $219 billion of California employees' retirement funds, will keep some money from these funds. CALPERs and its larger pension peers spend a lot time and a lot of money vetting new investments, so earning that initial spot in a pension portfolio helps keep a private equity firm alive in all but situations of extremely poor performance.

As U.S. investors scale back their private equity investments, the industry is increasingly looking to sovereign wealth funds and wealthy families in Asia and Latin America for new money.

"Funds are spending a lot of time overseas telling their story and thinking there's an appetite there," said Ernst & Young's Bunder. "That money doesn't come in overnight though."

For many private equity funds, that extended fundraising cycle could strike a fatal blow.