Thursday, July 31, 2014

Taking the Easy Way Out: Buying and Selling Private Equity Businesses

Taking the Easy Way Out:  Buying and Selling Private Equity Businesses

When making the pitch to public pensions and endowments, private equity firms tout the opportunity to add value by buying public companies, family-owned businesses, and orphaned subsidiaries of conglomerates.  The industry has argued that the private equity model enables them to make changes in businesses that aren’t possible under any other form of ownership.  As a result, a significant portion of the management fee is supposed to cover the process of sourcing deals.   According to The Wall Street Journal, over 60% of all acquisitions in 2014 have been between private equity firms.[1]  Only 3.5% of the acquisitions have involved public companies.  As the chart shows, this is a record and a trend.

This form of PE investment, known as “pass-the-parcel,” is extremely convenient for both the selling and buying PE firm.  The seller usually gets a clean exit from the business, because 100% of the company is sold.  If the selling PE firm exits via an IPO, it usually takes several years to actually dispose of the shares.  For the PE buyer, purchasing from another PE firm is easy and convenient.  The prospective business is neatly packaged and requires far less work to source and evaluate.

However, the prevalence of  “pass-the-parcel” undermines the central rationale of private equity.  If the goal of PE is to make operational and strategic changes in businesses, then the question is what’s the role of the second, third, or even fourth PE firm that own the company.  Shouldn’t the first PE firm have made the requisite changes over its five to seven years of ownership? 

These types of deals are bad news for investors.  Each “pass-the parcel” transaction is a great opportunity for banks to extract all sorts of fees for advising the parties, and to refinance the business’s high yield balance sheet.  It’s extremely expensive to buy and sell these businesses, and the investors absorb these expenses.   After the sale, many investors discover that they still own the business, less all the aforementioned transactions costs.  If they are investors in both the selling and buying PE firms, they’ve simultaneously realized the gain on their investment (less transactions fees and possible carry) and invested the proceeds plus additional capital right back in the business.

Private equity is in engaging in this practice because it is easy, and because they can get away with it.   So-called sophisticated LPs have failed to stop PE firms from charging portfolio companies with all sorts of consulting and monitoring fees.  “Pass-the-parcel” is merely another example of the inability of LPs to reach reasonable terms with their PE managers.  The LPs, especially big public pensions, are so desperate to increase their allocations to private equity that the industry is awash in capital.   The LPs generate reams of documents, but the actual terms of the deals greatly favor private equity.  Passing businesses from one PE firm to another is the fastest and most lucrative way to play the game.



  1. Bill Gross posted a blog yesterday forecasting historically low annual returns for most asset classes. Maybe he's right, maybe not, but his mindset explains why pension managers are desperate for better returns from PE.

  2. Desperation is always a terrible investment strategy