(Roughly) Daily

“If you don’t allow for self-serving bias in the conduct of others, you are, again, a fool”*…

Private equity firms are in the spotlight for their negative impact on health care, journalism— indeed, essentially every sector they touch in the interest of generating big returns for themsleves and their investors (some of which are sovereign wealth funds; some, very wealthy individuals/families; but largely, insurance companies and public pension firms). Now, as the inimitable Matt Levine points out, even those investors (who were already paying massive fees) are in the private equity firms’ crosshairs…

Two basic features of private equity economics are that if you raise a fund and you spend $1 billion to buy a company, and you do a good job running the company and it becomes worth $5 billion, then:

  1. You charge a management fee — say, 2% per year — on the $1 billion you paid for the company, not the $5 billion it’s currently worth.
  2. If you sell the company — to a strategic buyer or another private equity firm or in an initial public offering — you collect $800 million of carry (20% of the value that you added to the company), but you can’t charge the management fees anymore.

It would be good, for you, to mark the company to market. Raise your own new private equity fund, and sell the company from your old fund to the new one at its current market value. Then:

  1. You can keep charging 2% per year, but now on $5 billion rather than $1 billion.
  2. You can collect your $800 million of carry now, and then if you add more value you can collect more carry when you sell it.

This is called a “continuation fund.” The Financial Times reports on “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. As that era comes to an end and a downturn looms, these deals are set to become more attractive than ever for private equity groups with companies to sell.

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…

Equity market investors are becoming increasingly vocal about how private markets value companies. Vincent Mortier, Amundi Asset Management’s chief investment officer, said this month that parts of the buyout business “look like a pyramid scheme” because of “circular” deals in which companies are sold between private owners at high valuations.

Speaking privately, some pension funds are frustrated. “This is wonderful for the [buyout groups]; it’s one of the best things they ever discovered,” says one pension fund’s head of private equity, who asked not to be named.

But “it’s one of the worst things” for their investors, he adds. “The pie is getting bigger” as private equity balloons in size, he says, but “more of the pie is going to the [private equity firm] and less is going to [its investors].”

More on these Machiavellian machinations: “Buyout Firms Buy From Themselves,” from @matt_levine in @business.

[Image above: source]

Charlie Munger


As we ruminate on rapaciousness, we might recall that it was on this date in 1873 that Jesse James and his gang staged the first train robbery (the world’s first robbery of a moving train), a mile and a half west of Adair, Iowa… the site of which is now commemorated as a county park.



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