Private Equity Firms’ Incestuous New Strategy
Raise a new fund. Buy your old fund’s assets. Repeat.
In today’s highly competitive, highly valued private equity market, some general partners are choosing to buy portfolio companies that their firms already own, and simply transfer stakes from one fund to another.
Analysts at PitchBook said they have started to see private equity firms gather new money from investors for the specific purpose of holding onto old assets. Other PE outfits are buying portfolio companies from themselves in one-off transactions, such as Bridgepoint’s Europe IV fund selling its piece of Dorna Sports to Bridgepoint’s newer Europe VI fund.
“With fewer attractively priced buyout targets, GPs believe that reinvesting in some of their most promising current portfolio companies may be the best way to earn additional fees and carry,” PitchBook analysts Wylie Fernyhough and Zane Carmean wrote in a note published Monday. “GPs are therefore seeking ways to continue holding these assets with further upside potential.”
Since the financial crisis, PE firms have been holding onto their investments longer, in some cases extending the lifespans of their funds. Last year, one quarter of the portfolio companies that changed hands had been owned 7.1 years or longer by their GP sellers, while 10 percent had had the same ownership for at least 10.6 years.
The time horizon conflict is obvious: Buyout funds typically have lifespans of about ten years, or so GPs told their investors.
“Many of these assets are no doubt in ‘zombie funds’ from the financial crisis — funds where the GP is not collecting carry because the assets are performing poorly and little is being done to remedy the situation,” Fernyhough and Carmean wrote.
But the phenomenon goes well beyond zombies. Their analysis focused on “well-performing assets that GPs are loathe to abandon.” Speaking to Institutional Investor, Fernyhough explained that private equity firms believe they could be leaving money on the table by exiting investments when it’s time for a fund to be liquidated.
“This gives GPs the opportunity to stay with a proven company and continue to make good financial returns,” he said by phone. “Private equity firms have gotten more comfortable selling companies to other private equity firms — so why not just sell to yourself?”
To retain ownership of portfolio companies past fund expiration dates, general partners have gotten creative. Restructurings known as GP-led secondary transactions mean that a private equity firm “rolls one or more portfolio companies out of the original buyout fund and into a special purpose vehicle,” according to PitchBook. The same eggs, but a new basket.
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Then there’s the “nascent and novel strategy” of private equity firms gathering new money to buy aging investments.
“These stakes can be majority stakes or minority interests retained after selling companies to other GPs,” the analyst note stated. “For example, if a flagship fund has two promising companies to sell, rather than selling to another GP or pursuing a GP-led restructuring, the GP could instead sell it to a fund it managers specifically raised for this purpose.”
One high-profile example is TA Associates’ Select Opportunities Fund, which the firm began raising money for in 2019. The $1 billion fund “will purchase minority stakes in positions that the GP is exiting but believes still have marked upside,” according to PitchBook. Its investors include the Massachusetts Pension Reserves Investment Trust, Employees Retirement System of Texas, Tennessee Consolidated Retirement System, and New Mexico State Investment Council. (A spokesperson for TA Associates was not available for comment by press time.)
“While TA’s fund only seeks minority stakes, we can just as easily imagine funds that purchase majority stakes from prior funds,” Fernyhough and Carmean wrote in the note. “The strategy itself seems to be something a lot of GPs managing multiple strategies may pursue depending on the receptiveness of potential LPs.”
Fernyhough warned that these funds could be more prone to conflicts of interest compared to GP-led secondaries deals, as private equity firms could manipulate pricing in a way that maximizes their potential profits. Limited partners could also be forced to pay transaction costs or other fees for a deal that just involves moving a company from one portfolio to another.
“Self-sourced funds offer more possibilities for conflicts of interest to arise and disadvantage LPs,” Fernyhough and Carman wrote. “To provide a truly independent valuation assessment, we believe the GP should sell a piece of the company to management or other outside investors to ensure LPs in the buying and selling funds receive and pay a fair price.”
Still, investors might like having the option to intentionally sign on for an extension of existing deals — unlike in a GP-led secondaries transaction, which could “blindside” investors. PitchBook expects these funds to deliver lower overall returns with high success rates — which Fernyhough and Carmean said could be attractive for risk-averse allocators.
However, the lower returns could be a turn-off for others. The PitchBook analysts said that these funds would also give limited partners less control over their exposures than they have with secondaries transactions.
According to PitchBook, TA Associates will not charge a management fee on its hand-me-downs, but still takes a slice of any growth (or carry). With the fund retaining only minority stakes, an institution could end up invested in two different funds with exposure to the same company — and have to pay performance fees to both.
“There are a lot of potential conflicts of interest that could potentially keep this trend from really catching hold,” Fernyhough said. “We’ll have to wait and see how it plays out.”