Private equity’s secret bailout is ending

When you ask private equity executives about the financial crisis, they are quick to tell you that it wasn’t their fault. And that they didn’t receive a bailout. The first part is undeniably true. Private equity firms didn’t originate subprime mortgages, nor did they teeter on the brink of self-induced insolvency. The second part is a bit more complicated, and it’s only getting more so as the Federal Reserve orchestrates a rise in long-term interest rates.

From 2005 to 2008, private equity loaded copious amounts of debt onto thousands of new acquisitions, without regard that even a mild economic downturn could make it nearly impossible for those companies to repay their loans. All that saved them when their hubris hit the fan was Ben Bernanke’s fondness for interest rate limbo, which caused investors to flock toward anything that might produce an actual yield. These alternatives included leveraged loans, enabling private equity firms to refinance portfolio companies that otherwise would have gone bust. So while the U.S. government never cut tangible checks to buyout shops like the Carlyle Group or KKR, its lax monetary policy allowed such organizations a reprieve from some of their worst pre-crisis excesses.

That’s the history, and it’s probably for the best. Many state pension funds, universities, and nonprofit foundations rely heavily on private equity returns, and a rash of bankruptcies could have had far-reaching consequences. The refinancing boom, however, has begun to wane ahead of the Fed’s steps to slowly increase interest rates. The question now is whether past is prologue, or if private equity will effectively avoid the need for another de facto bailout in the event of another downturn. I’m expecting the latter for three primary reasons:

First, private equity executives generally concede that they overpaid for companies prior to the financial crisis and that they were lucky to escape with their cuff links. But don’t take their word for it — just look at what has happened in new deal activity. Private equity firms are flush with cash — $325 billion in “dry powder” when 2013 began, according to Cambridge Associates — and banks are eager to lend. Despite ripe dealmaking conditions, however, private equity firms are on pace to do less than 50% of the business that they did in 2006 or 2007 (a figure that is slashed by half again when looking only at U.S. deals). The mitigating factor is price, with buyout pros saying that just because they can do deals doesn’t mean they should. That’s something we almost never heard before the crash. And when firms do buy new companies, they are doing so at purchase-price multiples that are significantly lower than in the last boom time.

Second, during the financial crisis, private equity firms weren’t able to either refinance existing deals (credit crunch) or do new ones (unwilling sellers, due to depressed valuations). This forced many investors to roll up their sleeves and help their CEOs with issues beyond the balance sheet. If and when the Fed tapers its bond-buying stimulus, thus raising interest rates, there will still be plenty of PE portfolio companies that either didn’t refinance in time or didn’t refinance enough. For them, all that operational practice should pay dividends.

Finally, private equity firms once could raise new funds with the ease of dunking a five-foot basket, but no longer. Prospective investors have expanded their due diligence, taken harder lines on fees, and proved more willing to cut bait with underperforming managers. It appears to be a foundational change rather than a cyclical one. The result has been that private equity firms have been forced to remember the best interests of their “customers” and the real risk of business drying up. It’s the sort of thing that makes a private equity executive think twice before cavalierly entering into a new deal, particularly a large one. A check on excess, if you will.

To be sure, there will be plenty of lousy private equity deals and failed funds in the future. That’s just the nature of any investment business. But the next downturn won’t be likely to require a government bailout — even an unofficial one.

This story is from the August 12, 2013 issue of Fortune.

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