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Opinion

The ‘wacky dynamic’ at play in private equity

Private equity firms are on the hunt for new capital at a time when institutional investors are growing alarmed at the trend for buyout groups to sell companies to themselves.

Karen MaleyColumnist

Private equity funds are ramping up their efforts to raise fresh capital, even though the continuing turmoil in global share markets and the steep rise in interest rates have largely slammed the door on new listings, and caused buyout deals to slow to a trickle.

Scott Kleinman, co-president at Apollo Global Management told a Bank of America conference this week there was a “wacky dynamic” at work in the $US6 trillion ($9 trillion) private equity market at present, with an unusually high number of managers seeking to raise fresh capital.

Normally, he said, investors see 25 per cent of their managers raising money in any one period, but this year 75 per cent of managers are seeking to raise cash.

The fervid capital raising is taking place even though takeover activity has ground to a virtual halt, and is unlikely to recover any time soon.

“I would expect it is late next year before you see a real pickup in general M&A from the private equity industry”, Kleinman said, Bloomberg reported.

The determined efforts by private equity firms to raise additional capital look even more bizarre given that they’re already sitting on an estimated $US750 billion in uncommitted capital – cash that they’ve already raised, but which is yet to be invested.

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Scott Kleinman, co-president of Apollo Global Management: “I would expect it is late next year before you see a real pickup in general M&A from the private equity industry.” Bloomberg

But seasoned investors point out that private equity firms appear to be trying to raise extra cash to insure themselves against continued market turmoil.

As asset prices continue to fall, private equity investors, who are already nursing hefty losses on other parts of their portfolio will be less willing to contribute fresh capital, which will make it more difficult for them to raise cash going forward.

Already, there are signs that investors are increasingly offloading their stakes in private equity funds to other investors to raise liquidity.

What’s more, rising interest rates are hitting valuations hard, which will make it much more challenging for private equity firms to deliver strong investment returns.

But major institutional investors are becoming irritated that private equity firms are increasingly selling assets to their peers, or transferring assets between different funds they control. (Although they charge hefty management fees, private equity firms reap the bulk of their profits from the transaction – known as a carried interest – when the asset is sold.)

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This practice has been highlighted by Mikkel Svenstrup, chief investment officer at ATP, which is Denmark’s largest pension fund, who has warned of a potential pyramid scheme.

According to the Financial Times, Svenstrup told a private equity conference this week that last year more than 80 per cent of the sales of portfolio companies by the private equity funds that ATP has invested in were either to another buyout group or were “continuation fund” deals, where a private equity group shifts ownership of a company between two different funds that it controls.

“This is not good business, right? This is the start of, potentially...a pyramid scheme. Everybody’s selling to each other ... Banks are lending against it.”

Svenstrup predicted that the “exponential growth” of the private equity industry would stop “at some point”, saying that this was “just a question of time”.

There are some very, very good opportunities, but there are no miracles. Eventually there will be casualties...

Vincent Mortier, CIO, Amundi Asset Management

“It’s not that I think the private equity market is going to drop off a cliff”, he said. “We’re just going to be looking [at] potentially low returns and high costs.”

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Svenstrup’s comments echo those made by Vincent Mortier, the chief investment officer of giant European fund manager Amundi Asset Management.

In June, Mortier argued that parts of the private equity industry resembled a “Ponzi scheme” that will face a reckoning in coming years.

“You know you can sell [assets] to another private equity firm for 20 or 30 times earnings. That’s why you can talk about a Ponzi. It’s a circular thing”, he said.

Unlike asset managers that invest in public share and bond markets where prices can be tracked in real time, private equity firms invest in businesses whose value is much more difficult to ascertain.

Typically, private equity firms value these businesses by using some combination of discounted future earnings, and a comparison with the valuations of similar, listed companies

Mortier pointed out there were incentives for private equity firms to transfer assets between each other at inflated prices.

And he sounded a note of caution. “There are some very, very good opportunities, but there are no miracles. Eventually there will be casualties, but that might not be for three, four or five years.”

Karen Maley writes on banking and finance, specialising in financial services, private equity and investment banking. Karen is based in Sydney. Connect with Karen on Twitter. Email Karen at [email protected]

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