How to sell yourself has become the essential business of private equity

Private equity firms have a new set of buyers for the companies in their portfolio: themselves.

Blackstone, EQT, BC Partners and Hellman & Friedman are among the buyout groups that have sold companies to funds they control this year, or have plans to do so.

Although the model appeared before the pandemic, its use was ignited by it. Lazard estimates that the value of those deals will reach $ 35 billion this year, up from $ 7 billion just four years ago.

With the crisis making boards of directors more savvy about making deals, the private equity industry has found it harder to keep its simple promise to investors to sell portfolio companies to outside buyers after a period of determined detention.

“The recession that immediately followed Covid caused a decline in M&A markets and the ability to [private equity firms] to get out of those businesses by selling or publishing them, ”said Holcombe Green, global head of private equity at Lazard. “When traditional routes out are reduced, owners start looking for an alternative.”

Transactions allow companies to hang on to good companies – an interesting prospect as the industry’s $ 2.5 billion pile of unspent cash increases competition for new acquisitions. They also offer a solution if a buyout fund is nearing the end of its ten-year life but has not yet sold the companies in its portfolio.

To execute them, a private equity firm creates a so-called continuation fund, finds investors to back it up, and then uses it to buy a holding company already owned by one of its other funds.

At the heart of the process are groups called secondary funds, specialized asset managers who raise funds from pension funds and sovereign wealth funds. They invest more of their cash in continuation contracts, in part in the hope of generating faster returns than with a traditional 10-year private equity fund.

But as the trend accelerates, its inherent tensions are attracting attention.

Industry executives say this can be a way to offload struggling businesses that rival buyout firms, commercial buyers or public investors don’t want. This can leave the interests of those investors supporting the continuation vehicles to collide with those of the buyout company which sells a holding company back to itself.

“It’s either for very high quality companies that people want to keep, or for delicate companies that you cannot get rid of in any other way,” said a senior negotiator from a large European buyout group.

Some deals, for example, involve a set of businesses that may include “a dog and a star,” according to a senior private equity negotiator, because “if you just sell the dog, nobody will buy it.”

One fund manager who invests in vehicles said investors just need to be “pragmatic” about it. If a fund contains five companies of which “two are interesting and three are less interesting. . . you solve a problem for [the private equity firm] and you have access to high quality assets. ”

The momentum behind these deals – sometimes known as sidecar deals – is expected to build up next year.

“I think every private equity firm will consider doing something like this at some point,” said David Kamo, head of US private equity mergers and acquisitions at Goldman Sachs. “As a company, we are optimistic to organize ourselves” by hiring specialists in the field, he said.

For a buyout company, selling a holding company to itself is now an “option like selling to itself. [another company] is, like an IPO or sale to a Spac, ”Mr. Kamo said.

Chase vehicles: how it works

first stage

Original private equity fund: excluded company or companies

second step

Advisors call secondary funds, present the valuation of the private equity firm of the company (s) to be placed in the continuation fund and request offers

third step

The secondary funds indicate how much they would commit to the new vehicle and at what valuation. They may also include conditions on management fees and interest charged. Typically, if a transaction requires $ 1 billion of equity, two or three large funds would commit around $ 200 million each.

Fourth step

Once two big players sign up, the book building begins: Advisors collect the rest of the money from small investors on terms agreed to by the large groups. In the $ 1 billion example above, they can commit around $ 25 million each

Fifth step

Investors in the original fund can buy the new vehicle or make a withdrawal. The private equity firm is also expected to keep some of its own money in the new fund

sixth step

Company or companies transferred to a new fund

And with parts of the government bond market offering negligible returns, money is pouring into such deals. Pension funds have allocated $ 25 billion to such transactions for 2021, up from $ 14 billion this year and less than $ 8 billion in 2019, Cebile Capital estimates.

Ardian and Lexington, two of the largest secondary funds, have raised $ 19 billion and $ 14 billion respectively for funds whose mission includes such transactions. Goldman Sachs Asset Management could allocate about half of its $ 10 billion secondary fund to continuation vehicles, according to a person familiar with the matter.

As the financial power behind transactions increases, buyout groups are in a better position to set favorable terms.

Paying deferred interest payments to private equity firm executives – a lucrative 20% share of profits – in the previously small number of deals was prohibited, said Sunaina Sinha, founder of Cebile Capital. But it is now “standard”, she added. “If you look at the contracts made this year, in most of them they would have taken something home.”

Private equity firms reap other benefits, said Eamon Devlin, a lawyer at MJ Hudson, an asset management consultancy. This can, for example, increase their total assets under management, with a number of them using it to market themselves.

As the niche practice becomes more and more common, it is likely that surveillance will intensify. Establishing the price at which a portfolio company is sold remains the most controversial part of the process.

“AT [its] the heart is a conflict of interest ”, emphasizes Ms. Sinha, because“ the buyer and the seller are both entities controlled by the same [private equity firm]. There is “nothing wrong” with such conflicts, she added, provided a fair process is in place to agree on a price.

Some deals, such as Blackstone’s $ 14.6 billion sale of real estate group BioMed Realty from one of its funds to another in October, involve a “go-shop” process in which bankers solicit more bids. high for the holding company from outside competitors to see if the fund’s continued supply can be beaten.

But according to Ms. Sinha and Mr. Green, many such sales are not open to outside bidders.

Investors “want to understand what the real price discovery process was,” Devlin said. “Some [private equity groups] are ready with what the process was; some are not.