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March 15, 2024

Breakingviews: Buyout shops take risky exit to bypass deal crash

by Breakingviews.

Buyout firms have an even bigger problem than finding a place to park fleets of armored cars heaving with cash: what to do about their idling truckloads of portfolio companies. The two main avenues for returning money to increasingly itchy investors are largely blocked. To get around them, the existing owners are going down the road of cashing out backers while keeping assets. The problem is that more traffic will make this route riskier.

Clearing the backlog is a gargantuan task. More than $3 trillion of unsold investments are sitting inside private equity firms, according to a report issued this week by consultancy Bain. Moreover, they’re getting stale, with average holding periods reaching a nine-year high.

The surge in benchmark interest rates stymies the ability of buyers to borrow, while seesawing markets make it harder to agree on valuations with sellers. Deal activity between buyout shops fell 59% in 2023 from the five-year average and tumbled 32% by the same measure with industrial acquirers. Initial public offerings, meanwhile, were 80% off the half-decade average last year. Mergers are only just creeping back, listings far less so.

These dynamics have created a cash crunch. Pension plans, sovereign wealth funds, university endowments and other so-called limited partners are collectively contributing more money to private equity funds than they get back, making it harder to finance new commitments. As a result, the general partners, or fund-managing firms such as KKR, Bain Capital and TPG, are increasingly opting for Plan C, the mouthful that is single-asset, GP-led secondaries.

These transactions are morphing from one form of necessity into another. Many such secondhand deals originally involved groups of assets held by, for instance, divisions of banks under pressure. Irving Place Capital, a former unit of Bear Stearns, arranged a $1 billion plan to extend a struggling 2006 vintage fund following the global financial crisis. Under pressure from Dodd-Frank regulations, JPMorgan spun off its One Equity Partners investment arm. Big-name buyout shops only joined in earnest later, similarly starting largely with multi-asset deals, including Warburg Pincus selling a $1.2 billion slice of Asian assets in 2017.

But what if a general partner wanted to own just a single company beyond the agreed end date of the fund holding it? Any unrealized gains from a turnaround could be passed along, also allowing for the injection of new capital for acquisitions or other expansion.

Early versions included Hellman & Friedman moving software developer Kronos, which it had first acquired in 2007, from one pocket to another 11 years later with no new equity involved. By the time Blackstone struck a deal in 2019 to hang onto wireless mast operator Phoenix Tower International, the practice of moving a single, sizeable asset into a purpose-built continuation fund was formalized. Since then, such deals have grown steadily and look destined to become a regular part of the private equity playbook.

About a quarter of the bulging war chests earmarked for secondaries is now reserved for single-asset deals, investment bank PJT Partners reckons. Searchlight Capital Partners in November closed one for Integrated Power Services and Goldman Sachs Asset Management is seeking to extend its grip on Omega Healthcare in a transaction that could be worth at least $1 billion, Secondaries Investor reported in February. Although it is a crafty way to get capital back to investors, pitfalls abound.

The process of sounding out prospective investors about whether they would buy into a portfolio company at its last internal valuation – or some slim discount or premium – is easy enough, but there are reasons to be leery. Continuation funds often allow managers to keep collecting management fees on invested capital. The benchmark performance that an asset’s return must exceed for the manager to retain a share known as “carried interest” also can be reset. Some deals even push for “super-carry,” increasing a manager’s share of any return from, say, 20% to 30%. A transaction also crystallizes already-earned carry, which is usually received in-kind as equity in the continuation fund.

Protections are at least increasing. Fund agreements now usually require consultation with an LP advisory committee to clear conflicts of interest and lay out a deal’s rationale. The U.S. Securities and Exchange Commission also demands a fairness opinion, although these can be rubber-stamp exercises.

How to arrive at a price tag is evolving, too. There are competing philosophies about whether concurrently exploring a traditional sale of a portfolio company helps set valuations more efficiently, or if it instead implies that a continuation fund is a third-rate solution for a dud investment. Similarly, the idea of offloading a minority stake to another primary investor to set the price for a continuation fund, as KKR did with online media company Internet Brands in 2022, gets mixed reviews from practitioners.

Other factors help rein in managers, as well. With clogged exits pushing a flood of assets into the secondary market, fewer are finding a buyer. Despite seeing nearly $143 billion of potential GP-led deals of all types in 2022, there were just $53 billion of transactions completed, the biggest annual gap recorded by secondaries investor Hamilton Lane. In theory, this means suitors can be choosy.

Having a few seasoned firms – such as Carlyle’s AlpInvest, Ardian, Morgan Stanley Investment Management and Blackstone’s Strategic Partners – setting norms also helps. This is changing, however. The number of potential buyers contacted for an average GP-led transaction swelled to 26 in 2023 from 16 in 2020, private equity firm Whitehorse Liquidity Partners found. As retirement funds like Los Angeles-based LACERA and sovereign pools crowd in, it increases the risk that the disciplining mechanism of capital scarcity weakens.

With M&A and IPO opportunities having dwindled, buyout firms are understandably getting creative. More high-quality assets in the secondary market will naturally attract investors. GPs have strong incentives to make sure it happens. Despite the market’s growth, the amount of capital available is small, especially relative to the exit backlog. It means deals for bigger companies seeking multi-billion-dollar infusions would strain the existing universe of buyers. To make continuation funds a true third option for exits, that will need to change.

As such, the lines between continuation deals and garden-variety stake sales may blur. There are already indications that certain M&A-like practices, such as new investors winning observer seats on the portfolio company’s board, are rising.

For now, this burgeoning market is carefully balanced. Single-asset deals price on average at 92% of carrying value, a slimmer discount than other types of secondary transactions, PJT says, implying some confidence in what’s available. And Hamilton Lane says the returns are comparable to buyouts overall, but more predictable, with fewer outsize losses or gains. The challenge will be to stay on a steady path and stopping greed from letting things spin out of control.




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