Most of the attention regarding the private equity boom has surrounded the size of the deals (which are growing by the day, the most recent being Blackstone’s US$39 billion purchase of Equity Office Properties Trust), the massive use of leverage and the amount of money PE firms are making. While all those issues are relevant, one point that has been forgotten is the actual returns being generated by equity investors in PE funds.

While only a relatively small portion of the funding of a PE deal is made up of equity (usually between 10 to 25%) – that sliver of equity is essential in undertaking the acquisition. Generally, the equity is raised by PE firms soliciting funds from institutional investors like large public pension (superannuation) funds, banks, insurance companies, foundations and to a lesser extent, wealthy individuals. For example, in July last year, Blackstone raised US$15.6 billion in its Blackstone Capital Partners V fund while Providence Equity Partners raised just US$12 billion to focus on acquiring media businesses.

Despite their recent popularity among institutional investors, according to Fortune’s Rik Kirkland, a McKinsey study of PE fund performance indicated that the returns earned by investors aren’t matching the fees charged by private equity operators.

While the top quartile of PE funds performed well, “more than half [of the PE funds surveyed] came in well under the indexes, sometimes as much as 20% below.” Another University of Chicago/MIT study found that the average PE fund “trailed [the S&P] slightly after accounting for the private equity man’s cut.”

Further, according to Kirkland, George Siguler, managing director of PE firm Siguler Guff noted that, “historically, the highest returns in the buyout business have come from investments that were made during a recession or in the early stages of an economic recovery.”

As more PE firms bid for fewer assets, the price of those assets will increase – depressing returns achieved by the equity funds. The competition between firms is also compelling PE not only to acquire undervalued and inefficiently run companies, but also well managed companies like Qantas and Seven, and to endeavour to earn oversized returns through the use of debt rather than equity.

Commentators regularly point to the high use of debt as the major private equity risk factor. While debt loads are a critical issue (especially if interest rates increase), poor equity returns may become the silent killer of this private equity boom.