This blog has held the view that the vast majority of financial engineering we see today not only does not contribute anything significant to improving economic productivity and output but also has corrosive impacts and subtracts value from the economy. The financial engineering undertaken by private equity firms are among teachable examples.
The FT has a long read on circular trades undertaken by PE firms in the UK.
Belron and The Access Group are both long-established businesses that are far from the image of hot start-ups with revolutionary products. Located on the outskirts of Egham in the south-east, Belron repairs and replaces car windscreens; The Access Group, based just outside the Midlands town of Loughborough, sells back-office software. Over the past six months, investors have given both companies valuations that place them among Britain’s biggest companies — €21bn for Belron and £9.2bn for The Access Group. Belron’s valuation has climbed 600 per cent since 2017 and The Access Group has risen an eye-watering 3,800 per cent since 2015. Yet neither group has been exposed to the cut and thrust of public markets. Instead, their valuations were set in a new and controversial type of transaction that is fast becoming the private equity industry’s hottest trend in the US, UK and several other markets — deals in which a buyout group in effect sells a company to itself. Such deals have partly been a consequence of the tidal wave of cash that has flooded private markets during the long era of low interest rates... The deals — a way for buyout groups to return cash to their original investors within a pre-agreed 10-year time period, without the need to list companies or find outside buyers — have been growing in popularity since the early days of the Covid-19 pandemic, when a market freeze prompted a search for new options...
In the private equity industry, selling a company to yourself can take multiple forms, and dealmakers struggle to decide what to call the process. It is sometimes labelled a “continuation fund” or even, in the industry’s often-inscrutable jargon, a “GP-led secondary” or “adviser-led secondary”. A common feature is that a stake in one or more portfolio companies is sold from one fund to another, both of which are controlled by the same private equity firm. Deals worth $65bn were carried out this way last year, up from $27bn in 2019, according to Raymond James’ Cebile Capital unit...
In order to buy their own companies, private equity firms often raise money from a little-known group of specialist investors known as “secondary funds”... Secondary funds raise cash from pension and sovereign wealth funds — the same institutions that invest in buyout funds. They are flush with cash, having raised $78bn in 2020 and $37bn in 2021, a jump from $24bn the previous year... Many of these funds are in fact run by units of private equity firms themselves, with Blackstone, Ardian, Carlyle and Ares among those that have significant so-called secondaries businesses. The upshot is that these private equity groups are providing the funds that make it possible for other buyout groups to sell their own companies to themselves... private equity firms often arrange continuation fund deals without running a competitive sale process in which corporations or rival buyout groups are invited to bid. In those deals, the pension plans and other investors in the older fund selling the company say they cannot be sure they are getting the highest-possible price.
See also this.
For the PE firms, in times of plenty of cheap capital, investors accustomed to high returns, increasing difficulty of exits, and with scarce high-return investment opportunities, such circular trades offer several attractions. For one, it helps to deploy the vast amounts of dry powder mobilised and sitting idle. Two, it helps to generate high returns in a difficult environment. Three, it helps to redeem their existing investments. Four, it inflates transaction values and capital gains thereby increasing their fee returns, besides various other kinds of advisory fees.
Such transactions are not limited to the same PE group, but within the incestuous eco-system. Given the close links between PE fund managers and executives across leading firms, a system where you-scratch-my-back-and-I'll-do-yours (you buyout my entity and I'll yours) rife with conflicts of interests is not uncommon.
The incentive distortions and conflicts of interests possible are several. Capital is plentiful, investors too many, investments diffuse, fund managers not penalised for losses, and sorely inadequate regulatory oversight with whatever little being itself captured by the regulated themselves. Then there are the two big principal-agent or fiduciary disconnects - between the individual investors and the managers who deploy those funds; and the corporate entity of the private equity firm and its individual fund managers.
Capping it all is a permissive environment where, a la tax evasion and avoidance, what have traditionally been considered abusive and fraudulent practices done by stigmatised brokers in dark and shady corners have come to be feted as financial engineering conducted by Ivy League educated pin-striped executives in brightly lit swank offices. Underlining this, in recent weeks, Vincent Mortier, the Chief Investment Officer of Europe's largest asset manager Amundi warned that the inflated valuations make parts of the private equity industry looks like a pyramid scheme.
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