In the past year, about a third of New State Capital Partners' employees have left the private-equity firm as prospects for big payouts dimmed for some of them.

Employees had been counting on pay from the firm's second fund, which began investing in 2018. But the fund's portfolio companies underperformed and rising borrowing costs are expected to make it harder for New State to pay profits from the fund to its employees, according to people familiar with the matter.

Some of the dozen or so employees who left feared another one of New State's four funds could be facing similar challenges, and questioned the firm's likelihood of raising another new fund, the people said.

The New Rochelle, N.Y.-based firm, which was founded in 2013 and manages about $2 billion, is among the private-equity firms feeling squeezed by the challenges affecting the industry.

Firms that have already been struggling are bracing for conditions to get even worse with interest rates climbing. Higher borrowing costs threaten to dent the outlook for their portfolio companies, and make them even harder to sell.

The firms most at risk are relatively smaller -- managing less than around $15 billion -- and lack other lines of business that could help offset any troubles. Wall Street giants like Apollo, Blackstone and KKR, by contrast, have built multiple lucrative arms that can help offset weakness in any one unit.

"I do think we're pretty close to a period of reckoning," said Chris Wood, executive managing director at Huntington Bank, about the industry's midsize firms.

New State is far from alone in experiencing partner departures and economic pressures. Uncertainty over payouts is also pushing employees at larger firms to seek opportunities elsewhere, including at places where they feel they might have more prospects to advance.

The turmoil is most pronounced for firms with funds that started snapping up companies at peak valuations in 2020 through early 2022, when rates were near zero. Selling those companies for a profit has gotten harder as borrowing costs have climbed for potential buyers, meaning the estimated returns on potential investments need to be even higher.

The exodus at New State included two of the firm's three founding partners. A spokesman for New State said the firm's head count is relatively flat from a year ago when accounting for new hires.

"New State continues to return capital to investors while actively investing from its most recent funds," the spokesman said.

New State said all four of its funds are performing above the threshold it needs to clear to pay profits.

Grinding it out

The industry's continuing challenges have made it harder to attract new investor money, with private-equity fundraising on pace for its worst year since at least 2020. Firms have raised $222 billion this year through Sept. 30, compared with $330 billion for all of last year according to PitchBook.

In many cases, dealmakers' focus has shifted from making new investments toward grinding through portfolio operations, which many find less engaging, said Anthony Keizner, co-founder of recruiting firm Odyssey Search Partners.

"It's not the work or lifestyle that many of these guys entering private equity imagined and so that's leading to some disenchantment with the industry," he said.

Aterian Investment Partners, a New York-based firm that manages about $2 billion, is among those that have decided it won't raise a new fund.

Partners at the firm, which closed its fourth fund of around $830 million in 2021, have elected not to raise a fifth flagship fund, people familiar with the matter said.

Potential zero-carry future

At New State, some employees grew frustrated after a meeting earlier this year where they were told they might not see cash payouts from its second fund, in part because of underperformance, according to the people familiar with the matter. Word quickly spread to employees not present at the meeting.

The second fund's portfolio companies include KMS, a distributor of clearance consumer goods, and Klein Hersh, a healthcare-focused recruitment firm.

Employees worried that New State's third fund, which began investing in 2021, is headed for a similar fate as the second fund, the people said.

Payouts to employees from a fund's profit, or carried interest, often accounts for the biggest share of pay in private equity.

A fund can be above its hurdle rate -- the returns that must be hit before a firm can take profits -- but still not have the cash to pay employees. In those cases, employees generally receive only their base salary and bonus, which are funded out of management fees.

Bloomberg ranked New State's third fund as a top-performing fund under $500 million that began investing in 2021, as of June, based on its net internal rate of return. A firm's net IRR can be a misleading metric because it often represents a paper figure based on the firm's own valuations rather than actual cash in hand.

New State has continued to raise capital, raising $700 million for a fourth fund last year. The firm is also making a push in its independent-sponsor business, which it said has completed multiple investments.

Independent sponsorships, in which investment managers raise capital for each individual deal they back, have grown in popularity as a way to bring in capital during the fundraising slump.

"It's not free money anymore like it was seven or eight years ago," said Christopher Sheaffer, global vice-chair of Reed Smith's private-equity group.