Private-equity firms are finding that their best friends these days are other private-equity firms.
Buyout shops struggling with slumping demand for initial public offerings are instead selling their portfolio companies to rivals at a pace not seen since 2006. The trend reflects rough times for the industry — and risks upsetting their investors.
These private-to-private deals don’t bring the payoffs from IPOs or sales to corporate buyers that investors expect when they pledge their money to buyout funds. They are also increasing at a time when private-equity returns are falling, potentially making it harder for firms such as New York-based KKR & Co. to attract more money from pensions and endowments uncomfortable with the strategy.
“It does seem like a confluence of sellers looking for points on the board and buyers looking to put dry powder to work before an investment period expires,” said Robert Durden, managing director of private assets at Chapel Hill, North Carolina-based Morgan Creek Capital Management LLC, which manages $7.5 billion of assets for institutions and wealthy families.
Some of the biggest institutions, like the California Public Employees’ Retirement System, invest in many private- equity funds. That had made them both seller and buyer in effect in some deals, which can drag down their payouts. It happened at least twice this year to Calpers when private-equity funds holding the pension’s money sold Party City Holdings Inc. and TransUnion Corp. to other funds in which Calpers had also invested, scrapping proposed IPOs, data compiled by Bloomberg show.
“Secondary buyouts are not necessarily troubling, but limited partners may wonder what deal flow a buyout firm has if it is only able to find investments in another private-equity firm’s portfolio,” said Mike Kelly, a managing director at Hamilton Lane Advisors LLC in Philadelphia, which advises institutional investors including pension plans. “Limited partners begin to worry whether certain funds are pursuing these deals just to put money to work.”
The private-equity industry is turning to so-called secondary sales as a sluggish economic recovery saps demand for IPOs. Global initial offerings dropped last quarter to the second-lowest level since the financial crisis.
In the first nine months the flips have totaled more than $33 billion — accounting for one-third of private equity’s total exits, according to data compiled by Bloomberg and Preqin Ltd., a London-based research firm. That portion is up from 13 percent in the year-earlier period and the biggest share since at least 2006.
At the same time, IPOs and other public-market sales account for the lowest proportion of cash generated by U.S. private-equity exits since 2008, the data show.
In the first three quarters of this year, firms exited 54 investments through public sales, while flipping 115 to other buyout firms, the data show.
Private-equity sellers are increasingly under pressure to recoup cash from purchases made during the buyout boom of 2005 to 2007, when firms completed deals worth a record $1.6 trillion. Firms typically have five to six years to invest money pledged before starting to return it to backers.
“There were a lot of deals held through the downturn that have gotten to the point where funds want to exit,” said Donn Cox, the founder of Sacramento-based LP Capital Advisors and an adviser to Calpers. “Firms are recognizing getting cost back is better than holding an investment for another five years.”
The risk for buyers of flips is that target companies may have already yielded significant returns under their first private-equity owner, leaving less potential upside for the next firm that buys it, according to Durden. Private-equity firms frequently buy distressed companies, aiming to reverse their fortunes and make them profitable before reselling them or taking them public.
“They’re not necessarily turning up diamonds,” he said. “They’re buying other private equity-owned businesses.”
In addition, costs related to buying and selling a company amount to 1 percent to 5 percent of the purchase price, a charge ultimately paid by investors, according to Cox. To placate these investors, private-equity firms have been giving them a greater cut of fees levied on portfolio companies.
Limited partners such as Calpers, invested in both sides of a secondary buyout, are typically asked to contribute their proceeds from the sale to the buyer’s firm to fund capital commitments, delaying a payout.
Joe DeAnda, a spokesman for Calpers, declined to comment.
In the Party City deal, Calpers had invested in both the seller, Advent International Corp., and the buyer, Thomas H. Lee Partners LP, data compiled by Bloomberg show. Party City was headed for an IPO this year before it was sold in July in a $2.7 billion buyout.
TransUnion, which also planned an IPO, was sold this year by Madison Dearborn Partners LLC to buyers including Advent in a deal that valued the company at more than $3 billion. Calpers is a Madison Dearborn investor, too.
“Advent takes a highly selective view when analyzing a potential secondary transaction, ensuring that the same rigorous criteria are met as for a primary transaction,” the firm said in a marketing document sent to investors in March.
The shift to secondary buyouts comes as more than 1,900 firms were seeking to raise $796.5 billion as of Sept. 30, making it the most crowded fundraising market since the financial crisis, according to Preqin.
Yet investors’ enthusiasm for investing in new private- equity funds has cooled. KKR had raised $6.2 billion from early 2011 through October for its latest North America fund, the New York-based firm said in an earnings statement at the time. That’s less than the expected size of as much as $8 billion that Global Head of Capital and Asset Management Scott Nuttall gave on an Oct. 26 conference call with analysts. The firm is raising money for the fund through early next year, Nuttall said then. Kristi Huller, a spokeswoman for KKR, declined to comment.
Permira Advisers LLP, a London-based firm, has yet to lock in money from investors on a fund it has been marketing for more than a year, people familiar with the matter said last month. Noemie de Andia, a spokeswoman for Permira, declined to comment.
Apollo Global Management LLC is one of several firms that has lowered fees or offered special deals to entice larger clients. Leon Black’s firm, in the midst of raising a new fund of $12 billion, is sweetening the deal for investors by allotting them more of the fees it charges portfolio companies than in its prior fund, according to a marketing document.
Carlyle Group LP cut management fees for big investors in a $10 billion fund it’s seeking to raise, marketing documents showed in February. It took Blackstone Group LP about four years to raise a $16 billion fund, completing it in January. Melissa Mandel Kvitko, a spokeswoman for Apollo at Rubenstein Associates Inc., declined to comment, as did Christine Anderson, a Blackstone spokeswoman.
Executives in buyout firms including Carlyle and Blackstone have forecast lower returns in the industry amid slower economic growth. Carlyle, which has produced returns averaging about 30 percent over the past 25 years, is targeting gains of about 20 percent when doing deals now, David Rubenstein, co-chief executive officer of Carlyle, said in a Nov. 12 interview on Bloomberg Television.
Firms that increasingly rely on secondary buyouts are “trying to perpetuate an asset class that’s become very overcrowded and where the returns are going to be much less,” said Hugh Johnson, chairman of Albany, New York-based Hugh Johnson Advisors LLC and a member of the investment advisory committee for the New York State and Local Retirement System.
“It’s more a sign of weakness than strength,” he added. “It’s not as easy to be in that business anymore.”