Private equity’s new trend: selling to themselves
The decline in global M&A activity during the Covid-19 pandemic, combined with the ongoing lack of attractively priced targets, led to a rise in an alternative exit scenario for private equity firms: selling their portfolio companies to themselves, typically by creating a so-called continuation fund. Such deals are no novelty but given their rising popularity, a closer look should be taken at the potential pitfalls involved in such deals.
Typical scenarios and structure
A sale to oneself is often used in any of the following two scenarios:
- As a leeway to hang on to well-performing portfolio companies with good returns. This is one of the results of the trend of funds holding onto their investments longer, potentially beyond their initially planned life-cycle.
- Or as solution if a buyout fund nears the end of its life cycle but has not yet sold (all of) its portfolio companies. This is in particular the case where additional time is needed before a satisfactory exit can be achieved, a scenario which became more frequent due to the Covid-19 pandemic.
To execute such an older-to-newer fund sale, a private equity firm often creates a so-called continuation fund. Investors of the existing fund can either exit or reinvest/rollover in the new fund. This new fund is then used to buy one or several portfolio companies already owned by the firms' other (older) funds.
Such continuation funds are often expected to deliver lower overall returns but provide foreseeable returns given the familiarity of the fund with the portfolio company. As such, continuation funds are particularly attractive for risk-averse investors.
Potential pitfalls when selling to yourself
Such deals are an effective tool for proactive fund management. They potentially offer a satisfactory exit for both the investors and the private equity firm but at the same time carry a high potential for conflict of interests. Since buyer and seller are both controlled by the same private equity firm, the conflict between maximizing the value for its existing investors and paying the lowest possible price for the new fund is inherent (“sell high” and “buy low”).
Alternative sale options must have been assessed to demonstrate that the continuation deal is in the best interest of the existing fund as well as its investors. This is because the private equity firm may have its own benefits from a continuation vehicle (ongoing fees etc.). Furthermore, investors may be obliged to pay transaction costs for a deal that is simply about moving a company from one portfolio to another. Investors therefore want to be assured that valuations and terms of these transactions are fair both to the buyer and the seller and that no group of investors is prioritised over another.
Valuation of portfolio company
At the heart of a transaction is always the price. In order to avoid any conflicts, a fair process needs to take place to agree a price at which the portfolio company is sold. Therefore, it is important that the transaction is concluded at market conditions.
One way to mitigate conflicts of interest is to integrate an independent expert in the valuation process. The expert determines a fair market value or provides a fairness opinion to help ensure a fair valuation. Moreover, investors often negotiate and approve (either directly or through the investor advisory committee) the fund’s valuation methodology.
Another option is to seek a valuation point by reference to what others are prepared to pay. This reference may be achieved by way of allowing bids from the market or even the management or, if possible, by reference to a third-party sale of an interest in the portfolio company.
Furthermore, the funds must place particular efforts into making adequate disclosures to both groups of investors (via the respective fund investor advisory committees). It may also be advisable to establish and disclose valuation policies and procedures.
Andreas HinsenLocal partner Attorney at law
Andreas Hinsen, attorney at law, is a local partner in our Zurich office. He focuses mainly on private equity, domestic and international M&A transactions, corporate governance, restructurings as well as general corporate and stock exchange laws.T: +41434346700 E: [email protected]