Operational efficiency improvements with PE firms, and continuation funds

I have blogged earlier on an article by Daniel Rasmussen on private equity. In a recent blog post, Rasmussen uses data to question claims that private equity investments extract operational and management efficiency improvements to raise the performance of its companies. (HT: Robin Wigglesworth) See also this interview. 

He used the pre- and post-acquisition data disclosed by 993 PE firms that issued public market (bond sales) debt between 1996 and 2021 to finance their acquisitions (these cover a large proportion of the biggest deals). The operational performances of these acquired companies were examined before and after the takeovers on six metrics - revenue growth, EBITDA margin, Capex as a percentage of sales, gross profit to total assets, EBITDA to total assets, and debt to EBITDA - for three years before and after the deals, and compared to the aggregate metrics for public companies in the same sector in the same year (benchmark). 

This is his finding,

Having looked at revenue growth, EBITDA margins, capex spending, and return on assets, we don’t see any evidence in our sample for systematic operational improvements in PE-owned firms. These firms don’t seem to be growing businesses faster, investing more in growth, or gaining much operational efficiency.

But there's one area of clear outperformance

PE firms are buying quality businesses, leveraging them up, and not significantly deleveraging in the years post-acquisition. Debt is not significantly decreased after the deal and is actually often higher three years on than at the time of the deal. The PE firms are consciously effecting a permanent change to the target company’s capital structure. The industry mythology of savvy and efficient operators streamlining operations and directing strategy to increase growth just isn’t supported by data. Instead, there is a new paradigm to understand the PE model, and it’s very, very simple.

By and large, as an industry, PE firms take control of businesses to increase debt. As a result, or in tandem, the growth of the business and the rate of spending on capex slows. That’s a simple, structural change, not a grand shift in strategy or a change that really requires any expertise in management... The PE industry has created an effective and pervasive marketing myth that they are superior to individual companies, operating more efficiently and earning greater returns. But, as we have seen, this is largely fiction. The real reason PE firms want control of the companies they buy is not because of superior strategic insight but because they want to significantly leverage them.

On PE, FT has a long read highlighting the increasing importance of continuation funds, or the practice of PE funds selling stakes in their firms to themselves. This has remarkable similarities with the classic Ponzi schemes. 

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…

… 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. Data on sale prices would appear to confirm their worries. Forty-two per cent of continuation fund deals value the underlying company at less than the private equity firm had told the investors it was worth, according to research by Raymond James. Half value the companies at the same amount the private equity firm had estimated it to be worthand only 8 per cent are sold at a premium… Buyout groups respond that they give investors in their original fund a choice: they can become an investor in the continuation fund or walk away. But the idea of a real choice, with an option for the deal to be called off, “is a bit of a pink unicorn that never really exists”, according to a managing director at an investment firm that allocates cash to buyout groups. Several pension fund executives said they were given too little time to make the decision.

These funds are driven by the distorted incentives facing PE fund managers, 

Private equity firms and their dealmakers can reap great financial rewards from continuation funds — by charging their investors higher fees and taking a higher share of the profits… In simple terms, standard buyout funds charge their investors, such as pension funds, an annual management fee of between 1.5 and 2 per cent of the money they have committed to the fund. But once a fund has finished its so-called “investment period”, when it is buying companies — roughly its first four to six years — it stops charging fees as a percentage of the money committed. Instead it charges fees as a proportion of the money used to buy the companies that the fund has not yet sold. The effect is that buyout firms make far less in management fees in the later years of a fund’s 10-year life.

Selling companies in an older fund to a continuation fund lets the buyout group revive the flagging fee base. The new vehicle charges fees as a proportion of the amount it invested in a company — invariably a higher sum than the older fund paid. Then there is the carried interest: the 20 per cent share of profits on successful deals that can provide lucrative, and tax-advantaged, payouts to buyout executives. Dealmakers can receive those so-called “carry” payouts twice, once when a company is sold to the continuation fund and again when that vehicle later sells it, though they usually put most of the first payout back into the new vehicle. Carried interest is typically only paid out after a private equity fund hands a pre-agreed return to its investors, often around 8 per cent. If a fund looks to be likely to miss that target but contains a star company from which dealmakers would otherwise have reaped a large profit share, shifting the high performer into a new fund enables dealmakers to receive the payouts.

Better still for the dealmakers, in some cases they can negotiate so-called “super carry” on the continuation fund. Some use a tiered carried interest model where, if the company in the new vehicle generates less than a 20 per cent return for investors, the dealmakers would receive less than the standard 20 per cent profit share. But if it generates more, they can receive much more. Please use the sharing tools found via the share button at the top or side of articles. In a survey of the specialist investors that finance continuation fund deals, 68 per cent said they had funded at least one with a “super carry” provision, according to Raymond James. Those usually allow buyout executives to keep up to 25 per cent of the profits but in some cases stretch as high as 30 per cent.

As Eileen Applebaum says, the moot point is how long can the continuation funds continue in the face of rising interest rates and a weakening economy.