June 23, 2022

Breakingviews: Private equity’s short-termism has a rising cost

by Breakingviews.

Private equity dealmaking is getting a little too incestuous. Volatile markets and the $3 trillion industry’s sheer size mean that Blackstone, KKR and others will increasingly have to sell assets to each other – and even themselves. The merry-go-round can create governance concerns and extra costs.

The way buyout barons structure their funds typically encourages them to start offloading portfolio companies after around five years. Two of their favourite exit routes – selling to big companies and initial public offerings – are tricky given dicey markets. Buyout-backed IPOs declined 94% so far this year, Refinitiv data shows.

That’s one reason managers are increasingly selling assets to each other instead. Sales to other buyout shops accounted for 64% of U.S. private equity exits in the first quarter, compared with around 40% over the previous decade, according to PitchBook.

And in a new twist, managers are also holding on to companies by selling them to a new dedicated vehicle which they control, sometimes backed by the same investors. Such so-called continuation funds doubled last year to $52 billion, Lazard reckons. EQT Chief Executive Christian Sinding said at a recent Reuters Newsmaker event that he expects them to keep growing. One example is Clayton, Dubilier & Rice’s 21 billion euro sale of windscreen maker Belron.

Neither scenario is ideal for investors like pension funds, who often give money to several big buyout firms. They may own stakes in both the buying and selling funds, and so end up with the same asset, minus transaction costs. Oxford University’s Ludovic Phalippou reckons these expenses, like banker and lawyer fees, can be 3% of the company’s enterprise value.

Continuation funds, meanwhile, have an added governance problem. Since these deals involve a buyout group selling the asset to itself, there are fewer checks on the fairness of the price. That makes it hard for investors to tell whether the firm is doubling down on a winning bet or avoiding a loss on a bad one. The trades may also allow managers to boost performance fees, for example by taking a good asset out of a fund that is unlikely to meet its return targets.

There’s a simple solution. So-called long-life funds, which hold assets for a decade or more, give buyout barons the flexibility to sell when the time is right. According to Bain & Company, the lower transaction costs in such funds can double returns over time. That gives private equity investors all the more reason to push for change.

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