SOME of the ageing superstars of private equity dismiss current predictions that competition will drive down returns. They have heard it all before. “There are still lots of great deals out there,” says Thomas Lee. “The past couple of years have been a golden age for private equity.”

There is some truth in this. The years immediately following the tech bubble, the economic slowdown, the terrorist attacks of September 11th 2001 and the collapse of Enron offered plenty of opportunities for private-equity firms with the courage to invest. Soon after September 11th, several private-equity firms set up a clutch of catastrophe-risk insurance companies based in Bermuda, which have now been sold at a huge profit. “We should have bought everything in sight after 9/11,” says Mr Lee. “It needed minimum brains, maximum guts to do those deals.” At the same time, big companies such as GE and Tyco, which had hitherto been competing hard with private-equity firms for potential acquisitions, backed away from the market or even became eager sellers of non-core businesses.

Yet this period may prove to have been only a brief reprise of the high returns of private equity's early years, not a sign that the industry has put its troubles behind it. Nowadays even the best private-equity firms are mostly aiming to achieve annual returns of only 15-20% on their capital, down from 20-25% in the 1990s and over 30% in the 1980s—though in the buy-out business they still hope at least to double their money on every investment. Private-equity firms now talk much less about the absolute returns they expect to make. Instead, they promise better returns than those available in public equities—which, given the stockmarkets' miserable performance lately, may not be saying much.

Some make bigger promises than others. “We expect to do 2,000 basis points better than the market in all conditions,” says the boss of one big firm. Carlyle is aiming for 1,000-1,500 basis points above the market. Most firms, however, feel that investors would settle for 600 points better than the stockmarket as sufficient reward for the illiquidity and, perhaps, the greater risk of private equity.

For a variety of reasons, returns may fall short of even these modest targets. There is already lots of capital chasing deals: some $100 billion has been raised but not yet invested, hedge funds are piling in and a new cycle of fund-raising is getting under way. So far, funds with a good reputation are finding a keen response from investors, especially in Europe: Allianz, Germany's biggest investor in private equity, has said that it is planning to invest much more. Bain Capital recently raised a $4 billion fund in only a few weeks instead of the usual few months.

In the past, private-equity firms were able to do a fair number of “proprietary deals” in which they had no competition. Now, even though the number of deals is increasing, all but the smallest firms are sold through a competitive auction organised by the seller's investment bank. Competition can be intense, with deals attracting from half a dozen to many dozens of bidders, and auctions almost always result in higher prices.

Private equity thrives on finding inefficiencies to exploit. Fees aside, there are several well-established ways for its firms to make money. The four main ones are:

•Improve the profitability of the companies they buy, so that they can sell them for more than they paid for them.

•Buy low, sell high. Some companies fall temporarily out of favour with investors, so their shares trade at a low multiple of their profits or cashflow. Private-equity firms can buy them and wait until the market is more bullish and multiples are higher (though they may find that there was a good reason for the low valuation). Valuation multiples also tend to rise as firms get bigger, so simply holding a business and letting it grow may boost its multiple from, say, six to eight over a few years.

•Break it up. Some businesses trade at a value that is less than the sum of their parts. They can be broken up and sold in pieces for more than the purchase price. Some part of the business may distract management from a company's core operation or drain scarce resources from it. Selling it off not only raises money but may also result in a more focused and therefore more valuable core business.

•Use leverage. Borrowing can multiply any gains made by the first three methods. A private-equity firm buys a company for, say, $100m. It pays for it with $10m of its own equity capital and borrows the remaining $90m. It later sells it for $110m. After repaying the debt, it has doubled its money even though the value of the firm has increased by only 10%. The risk, however, is that if things go badly and the private-equity firm is unable to service and repay the loan, its capital may be wiped out in the bankruptcy courts.

In practice, many private-equity firms deploy all these methods. But broadly speaking, in the 1980s, when debt was plentiful and target companies were not highly leveraged in the first place, private-equity firms concentrated more on finding undervalued assets, selling off the pieces and greatly boosting their yield with leverage. In the 1990s, the increasingly bullish stockmarket allowed such firms to benefit handsomely from rising price-to-profit multiples. Today, the firms may have to earn most of their money by improving the companies they own.

One problem is the commoditisation of many of the activities that gave private-equity firms a competitive advantage in their early days. When people such as Henry Kravis started doing deals, the effective use of leverage and the importance of cashflow was a mystery understood by only a few; now it is taught in every business school. Private-equity firms have become a huge source of business for all sorts of professionals, from consultancies, executive search firms and back-office companies (such as BISYS, the industry leader) to law firms and investment banks (Blackstone alone paid Wall Street firms around $700m in fees in 2003). As a result, the techniques of doing deals have become standardised. That has lowered risk but increased competition by making it easier for less experienced firms to bid.

Ultimately, private equity is all about making a successful exit. The traditional solutions are either selling to a trade buyer (typically a company in, or trying to get into, the same industry as the firm being sold) or turning the firm into a public company via an IPO. In the past two or three years, both of these exits have become narrower than they were during most of the previous decade.

Many of the IPOs that took place during the tech boom subsequently melted down, so now investors have little interest in buying shares in start-ups without a record of profitability. Google's IPO earlier this year may have attracted a lot of attention, but it has not made investors much keener on other tech IPOs. Most private-equity firms believe that it will be years before the IPO market returns to the levels of 2000—if indeed it ever does.

At the same time, corporate buyers remain reluctant to make all but the most obviously sensible acquisitions. Under pressure from shareholders, their boards have come to regard the large number of ill-advised takeovers and mergers during the bubble years as evidence of corporate-governance failure during that period.

Helpfully, two new exit routes have opened up in the past few years. The first is recapitalisation. Recently a few second-tier banks have become much keener on lending to finance private-equity deals. They are now willing to value firms at much higher multiples of profits than even 12 months ago, and to lend against those values. Many private-equity firms have taken advantage of this to “recap”: increasing the amounts borrowed by the firms in their portfolios, then using the extra money raised to make dividend payments that the fund distributes to its limited partners.

Will this exit stay open for long? There are only so many times a firm can be revalued and recapitalised. Recaps are anyway only a partial solution, for the firm still remains in the hands of its private-equity owner. And it may not be prudent for banks to lend at such high multiples. It would not be the first time that their pursuit of loan origination fees has led to laxity in their credit judgments. When they or their regulators notice how lax they have become, this particular door may slam shut just as suddenly as the IPO one did.

The other currently fashionable exit strategy is for one private-equity firm to sell to another, a technique known as a “secondary buy-out”. (This should not be confused with the “secondary market” in which one investor can sell its limited partnership in a fund to another investor. This market is also growing fast.) Over the past two years, secondary buy-outs have accounted for a rapidly rising proportion of sales by private-equity firms.

Some observers view these “buy-outs of buy-outs” as evidence of the growing maturity and specialisation of the industry. Others wonder what they will get out of this game of “pass the parcel”. “The results of these deals may prove most disappointing,” says Michael Stoddart, a British private-equity veteran at Fleming Family and Partners. Anything the buyer could do to improve its acquisition may already have been done by the seller. And what is the benefit to the limited partner who has invested in both the buying and the selling private-equity firm and thus ends up still owning the firm that has been sold, minus the fees for the general partner of the selling fund? Some limited partners even worry that such deals may involve some mutual back-scratching, in which one firm buys from another on the understanding that the seller will later return the favour.

There is another exit that private-equity firms are increasingly having to think about: that of their top brass. As the industry has matured, so has its pioneering generation of leaders. The duo in charge of KKR, Mr Kravis and George Roberts, are around 60, as is Mr Lee. Teddy Forstmann of Forstmann Little is 64. Increasingly, limited partners—who, after all, must lock up their cash with private-equity firms for many years—want to know who will succeed the current bosses, and when. So, too, do the candidates who might take over. Lionel Pincus, now 73, lingered so long at Warburg Pincus that when he finally gave up operational responsibility, a whole generation of heirs apparent had left.

Some firms have embraced succession planning more willingly than others. The founder of Apax, Sir Ronald Cohen, set a mandatory retirement age of 60 long before he himself reached it. Apax now has a new chief executive, Martin Halusa, 49. At Permira, power has passed smoothly to a new generation. Mr Lee has delegated day-to-day responsibility for his firm to others. TPG's David Bonderman now describes himself as more a chairman than a chief executive. Blackstone has recruited an emerging next leader, Tony James.

By contrast, Forstmann Little, which has failed to develop any potential successors to Mr Forstmann (and has also put in an abysmal performance recently), recently announced that it will go out of business when Mr Forstmann retires in 2006. Mr Kravis, for his part, plans to stay at the helm for many more years. He says that KKR has a deep bench of talent, so there is no doubt that the firm will thrive after him.

What should a founder be paid for giving up his partnership? Founders tend to have a large stake in their firms, so buying it could be a serious drain on the finances of the remaining partners. Apax's partners had a meeting to agree on what they regarded as a reasonable price. Other strategies for cashing in the founders' stakes, much discussed in private-equity circles, include selling the firm to a bigger financial institution, or floating it.

The trouble with replacing a set of highly charismatic founder-leaders is that their successors may seem less inspiring. As one limited partner put it, they will certainly “all be very bright and numerate, with MBAs, very analytical. But I worry they may be more like bank officers than deal-making geniuses.”

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