How much of PE is just playing musical chairs with the same assets?

IB analyst here so might be off base, but it feels to me like PE currently is just passing around a bunch of companies to other PE firms at higher and higher valuations without any focus on intrinsic value. I'm in tech so maybe this is an industry issue, but it makes me a bit worried about a future career in PE.

In my last deal, a huge focus of the buyer (a big MF/UMM) was their ability to sell the company again in 4 years. They were literally focusing on what firms might buy it instead of improving growth/margins/etc. The play today is clearly buy something, do a bunch of bolt-ons (which again feeds into the whole PE ecosystem), show a ridiculous growth rate from these acquisitions and then sell the thing at an insane multiple. Every deal I've been on at my IB job has been this exact playbook.

None of the PE deals I've seen are making money off dividends, FCF to pay down debt, financial engineering, or any of the "textbook" PE money making plays. They're literally just trying to sell the thing for more in 4-6 years. Hire a bunch of sales reps, juice EBITDA margins with some funky accounting, and get a great growth rate. Maybe once in a blue moon a company manages to go public or get acquired by a strategic, but my general take of the PE ecosystem today is KKR makes money selling their port co to Warburg and Warburg makes money selling their port co to KKR. Everyone is taught strategics should pay more due to synergies and so on, but every process I've been on PE bids are way higher than strategics, and my MDs often don't even bother calling strategics because they assume PE will pay more, which just shows how much PE firms are overpaying now. At some point, it feels like the music has to stop and all these firms will be stuck with overvalued assets that no one (public markets/strategics) wants to buy and returns will go to shit, and the current success of the industry is just a cycle of PE firms raise more money -> PE firms deploy capital by buying expensive assets from other PE firms -> PE firms post great returns due to these inflated prices caused by competition among all the PE firms that just raised huge funds and have pressure to deploy -> PE funds use great returns to raise more money and the cycle repeats.

Comments (64)

  • Incoming Analyst in IB - Gen
Nov 17, 2021 - 12:23am

damn i was wondering the same thing. started browsing some pages and noticed lytx as a portco for like 5 firms lmao

  • Prospect in IB-M&A
Dec 7, 2021 - 12:53am

How do continuation vehicles work? Wouldn't LPs see this and be weary they they aren't "real" exits. Also are continuation funds more popular in PE or Private credit?

Apologies for all the questions but would love your thoughts

  • Analyst 1 in IB - Gen
Nov 17, 2021 - 9:51am

Making money is a all a game.  The sooner you realize that the better.

  • Associate 1 in IB - Restr
Nov 17, 2021 - 11:06am

Doesn't always work out.  See it all time in the RX world that PE firm A acquires a company from PE firm B, does several bolt-ons, finances each w/ new debt, bolt-ons and/or core business begin to underperform, leverage becomes unsustainable and the Company isn't marketable anymore, cash burn intensifies, equity winds up getting completely fucked. 

  • Analyst 1 in IB-M&A
Nov 17, 2021 - 1:53pm

Any sense if this is getting more common in recent years? I haven't been in the industry for a super long time but from my understanding, sponsors are getting more and more aggressive with this strategy and I'd imagine they'll be ending up in RX more frequently as well

  • Associate 3 in IB-M&A
Nov 17, 2021 - 10:30pm

Not in the RX world but anecdotally it's definitely on the rise. The market is so competitive these days you have to have some creative bolt-on, major expansion, etc to justify the premium you're paying for just about anything these days, and even in experienced hands a large number of those fail. Much harder at current prices to just run the business well on a standalone basis and exit anywhere near your target returns.

  • Associate 1 in IB - Restr
Nov 17, 2021 - 2:46pm

My experience only goes back 3 years, so can't speak too much to how common it was before then, but the direct lending market has gone gangbusters, so leverage is getting pushed and covenants / incurrence provisions have become infinitely more borrower friendly than they were before the pandemic.  

However, have seen a lot of names that fit the description of my initial post since I started.  Over the last 3 years (back when WTI was ~$30 aside), I would say that excessive leverage due to aggressive financing of underperforming bolt-ons is a material contributing factor in ~1/3 of the private names that hit our radar.

Nov 18, 2021 - 12:39pm

I've seen a lot of this as well. 8 and 9 figure facilities for barely viable businesses, debt to pay back other debt and kick the can down the road, and all sorts of intercompany "loans" between portco's (aka just raiding balance sheets for the benefit of the PE). It makes me wonder if the lenders are engaging in the same song and dance internally or just that desperate to deploy capital. 

  • Associate 1 in IB - Restr
Nov 18, 2021 - 4:05pm

Those guys are just desperate to get $ out the door and incredibly thirsty for yield.  Have seen / been on multiple private non-sponsor backed deals where direct lenders have put significant amounts of pref into deals to plug liquidity gaps as part of a financing.  Engagements like this that I've been on were all company side, but I imagine the lenders know that they're putting equity into a dog shit company, but can't say no to a 15% coupon.   

  • Analyst 1 in IB-M&A
Nov 17, 2021 - 3:11pm

Yup. Was recently on a deal where the company did something like 12 acquisitions in the past 3 years and did 3 acquisitions over the course of our sell side. Have a hard time believing that there is any value/synergies in that many acquisitions, especially if they're not taking the time to actually integrate anything. But alas, buyers paid for the insane 2022 growth projections…

  • Associate 3 in PE - LBOs
Nov 17, 2021 - 3:10pm

Too much dry powder chasing too few quality assets.  Many large funds have gone downstream to chase returns, so a founder-owned business can sell to an institutional investor at $3mm of EBITDA instead of waiting to get to $5-10mm.  Far less operational juice to squeeze going PE-owned to PE-owned versus founder to PE-owned  

Unless interests rates rise and/or LPs allocate away from PE if returns converge with equites, likely to see this continue.  

  • Principal in PE - Other
Nov 17, 2021 - 4:58pm

This is why one of the things I look at when making LP commitments is analyzing by portfolio company who the seller was when the GP bought the company. Everyone loves to say they're sourcing proprietary deals and not buying from other sponsors... it's important to check the numbers and see if the data backs up the claim. I try to avoid putting money with GPs who are playing this game of musical chairs.

  • Analyst 1 in IB-M&A
Nov 17, 2021 - 8:45pm

How possible is it even for an MF to avoid just buying from sponsors? Can't imagine there's that many privately owned companies worth $1B+, so for a fund that needs to deploy billions, seems almost impossible to do the proprietary sourcing for deals that big. Can do take-privates of public companies which we see the Thoma etc do, but that comes with it's own issues (needing to overpay for an already expensive asset in terms of multiples). I get that's why lots of bigger funds move down stream, but even still there's so many PE funds that seems like everything that can be bought by a sponsor has already been bought by one

  • Associate 1 in PE - Other
Nov 18, 2021 - 9:20am

It's not so much "don't buy from sponsors" as a blanket statement (though there are some firms that really pride themselves on being the first institutional capital). But there are certain sponsors that you pretty much never want to buy from (Vista comes to mind) where you'll have a much more limited toolkit to generate some value from the business. If you're looking at a GP's track record and see a lot of those types of sponsors as the source of their portfolio companies, you better be really confident that they still have some value-add.

  • Principal in PE - Other
Nov 18, 2021 - 11:46am

It's really tough for a MF to avoid buying from a sponsor all the time. As an LP there's an easy solution: don't invest much with MFs. The returns from most of them aren't even that good and if you look at a PME, you might as well just put your money in public markets. The people who are putting their money with a lot of MFs either need to write really large checks themselves (the largest pensions, SWF, etc) or are lacking in imagination.

  • Intern in RE - Comm
Dec 19, 2021 - 8:25pm

You build an apartment with a fund that is okay with more risk at a 6% yield and sell it at a 4% cap to one of your less risky funds. Ex: 100 million dev cost at 6% yield returns 6 million in NOI, and you sell the asset for a 4% cap, and you would get 150 million (profit of 50 million). Add leverage, and you get fuck you money as a GP. Smaller regional developers or a place like Hines where every team in each city for each asset class is two people, you have the potential to make a boatload of money. 

  • Analyst 1 in IB-M&A
Nov 18, 2021 - 2:23am

If you want to really have your mind blown-see if your firm tracks multiples paid over the last 10 years. Notice how you could have bought a borderline garbage company and still made an absolute killing due to multiple expansion alone. 

The simple truth is private equity and asset allocators believe beta is alpha. Most the returns these firms are getting is due to leverage and multiple expansion, not some unique strategic angle or intrinsic value. If you use leverage and prices go up, you get very wealthy. If the reverse happens, you get underwater very quick. The reverse hasn't happened in 13 years.

Further, since you have people that are 13 years into their career who have never seen a correction, firms have big decision makers that are fearless (recklessly willing to pay anything) because it has worked throughout their entire career. Also, the field has been so successful as others have mentioned, everyone is just tossing their money in private equity firms and everyone and their monther is raising a fund because they don't want to miss out. I was on calls as an analyst years ago where people where saying things like, "we know we will overpay, but we have too much capital to put to work" I can't imagine how they must feel today.

It's obviously a bubble and when it goes funds are going to be underwater and the industry will see some consolidation, but with this current fed who knows when that will be. Also, it's not just private equity, you see the same thing in equities where companies like Tesla or really most tech companies out there are being bought because it has only gone up and no one has ever seen the reverse to be true. Despite the fact that anyone with a pulse recognizes the valuations of these public companies is so warped a 8 year old would say, "yeah, that doesn't make sense"

Should have bought amc, Bitcoin, and invested in a private equity fund 10 years ago.

Nov 18, 2021 - 8:11am

Is it possible a big fund like KKR or Warburg goes under if interest rates were to increase beyond expectations? What is the ultimate downside scenario?

  • Analyst 1 in IB-M&A
Nov 18, 2021 - 9:55am

They wouldn't really go under. More likely/ realistically across the industry they will just increase hold times, have worse returns, and fundraising will be harder. You already are seeing the first two a little to be frank.

Nov 19, 2021 - 1:06pm

The simple truth is private equity and asset allocators believe beta is alpha. Most the returns these firms are getting is due to leverage and multiple expansion, not some unique strategic angle or intrinsic value.

I get in this argument all the time. I tend to agree with you, looking at private equity as an asset class.

There still exist pockets of private equity that are alpha creators. When the GP applies unique, specialized knowledge or efforts that alter the course of the business such that the business's future cash flows grow, are de-risked, or both, then the GP has created value and should be rewarded for it. (A GP can still apply knowledge or efforts that aren't particularly unique - the "blocking and tackling" argument - and get paid for it, but then there's a fair argument about whether or not that's truly alpha-creating or if it's just regressing the earning potential of the asset back to the mean.)

"Gee, thanks, Layne," most of you are saying. No surprises in the above paragraph. The surprise, if there is one, is that those conditions are really rare in today's private equity marketplace, and even less so as you get into the middle market and up. The more that smart people with similar skillsets are chasing the same assets, the more the market bends to efficiency, and the less alpha is available to be captured by any one actor.

Inefficiencies still exist in the lower middle market, because the opacity of information about business performance and about risks can create information asymmetries that a GP can monetize. Unfortunately to me, it seems like often in this end of the market the information asymmetry is around value / purchase price, and a sponsor can end up paying an artificially low price for a business because the prior owner lacked the context of the market's view on value. When that happens, I would argue that the GP isn't really finding alpha, they're monetizing another party's information deficit and capturing an outsized portion of it for themselves (and their LPs).

I find that it's more rewarding to effect real changes in a business such that value has been created, and the asset is better as a result, and that additional value is what the GP gets paid for. It's certainly harder than the above scenario, but I get more intrinsic satisfaction from it.

"Son, life is hard. But it's harder if you're stupid." - my dad
  • 10
Nov 26, 2021 - 2:09pm

I mean datasets like Preqin exist. If you look at the fund vintage returns, that's your benchmark right there. You can further subdivide into industry as well if you think it's industry based.  

Nov 18, 2021 - 7:46am

This is a huge pitch of the more operationally hands on firms, particularly in the middle market. They're actually buying first time institutionally backed businesses, which have a ton of value creation opportunity.Once you get to MF and UMM world, there are so few assets that haven't been PE backed and so much capital, the math just doesn't work as well.

Nov 18, 2021 - 8:21am

OP you're not wrong - this environment basically is a function of the last 10yrs where we've had a continuous bull market and insanely low interest rates.

Myself I work in PE (associate at a MM shop) but fortunately we've walked away from any ridiculously overpriced deals. However I have a number of ex-IB colleagues at mega funds who have worked on/been responsible for acquisitions over the last 5-6 years which I've thought were insanely overvalued. As much as I wanted them to do well, I kept thinking that as soon as rates started rising the value of these investments would get vaporised - and it was only a matter of time.

But that didn't happen - in fact even some of the most overpriced acquisitions they made in 2016-2019 have since sold for huge multiples. These guys are now all VPs or Principals at mega funds and making close to $1m+ annually in their early 30s. 

Don't get me wrong, these guys are very smart and hardworking - but also they've definitely been in the right place at the right time (same for guys who made millions in the run-up to 2007). And not to discourage you/give bad news - but while I'm sure PE will continue to be a lucrative career for many years to come, I certainly wouldn't bank on making the same $$ that guys (who are probably no smarter/hardworking than you) have made over the past few years. Especially if rates do finally start to go up.

Nov 26, 2021 - 2:11pm

I completely agree. A lot of these returns are also driven by tech, which has been in a 20 yr bull market. Once tech enters an extended bear market (would think in next few years), we're going to see massive underperformance, maybe even negative returns, from the MFs and VCs.   

Nov 18, 2021 - 11:26am

I think you caught on to something pretty serious. 

This sounds like a time bomb.And when it blows, the economy sinks with it. (Because this "cycle" is just not sustainable and the bubble will pop)

How much of the economy do you think is exposed to this? (As percentage of the GDP, total income, total assets) 

What areas of the economy do you think is gonna be impacted if this crashes? (Industries, regions, socio-economic classes, etc...) (in terms of what jobs are at stake, what parts of the supply chain are involved, etc...)

What are linkages btw these private market deals and public markets?

Is there enough economic decoupling mechanisms built in to prevent catastrophes if this trend does crash?

Nov 18, 2021 - 11:46pm

Hate to be the ass here but this isn't some epiphany.

PE investing goes in cycles. Folks have been lucky the last 12 years to have every very low rates and cheap debt and printing tons of money. This cycle has been great. 2005 -2008 vintage sucked. Don't complicate this guys Yes eventually the bubble will pop but let's no turn WSO into ZeroHedge through a bunch of 23 year olds commenting.

Life is more than dollars
  • 3
  • Associate 2 in PE - LBOs
Nov 19, 2021 - 1:23am

Agree with the above. These aren't new questions or profound topics. Everyone knows the market is frothy and there are more sponsor-to-sponsor deals than ever. It's a function of the industry maturing vs. 10-20 years ago. 

Separately, any half-decent private equity firm is thinking about where returns are coming from (e.g., multiple expansion, deleveraging, etc.). I guarantee you that no quality sponsor thinks they will get multiple expansion buying companies at all-time high multiples. 

Nov 19, 2021 - 7:10am

That's a fair point and my intentions weren't to start some sort of ZeroHedge thing (idk what that is but I get the message).

That's why I'm asking questions about how impcatful this could be. This is hardly a revelation like you said since this is just how cycles works. But at some point the party will stop and there has to be some sort of a downturn.

A good way to understand that IMO would be to see how much of the economy is related to this "buy at all time high" behavior, how much of the deal flow is driven by it, what decoupling mechanisms are in place to prevent the damages from spreading.

In a way, most recessions that started from bubbles bursting were aggravated by lack of proper decoupling mechanisms that could isolate the sourcee of the problem and stop the "disease" from spreading. (Softly quoting Andrew Lo here)

Nov 18, 2021 - 2:01pm

At the end of the day there are only 3 true end buyers.  

1) Public markets

2) Bigger PE firms or bigger industry players

3) The original business owners when they inevitably buy the company out of bankruptcy for pennies on the dollar becuase the music stopped.

I have seen 3 happen personally almost a dozen times now.

  • Analyst 1 in IB-M&A
Nov 18, 2021 - 8:50pm

In theory though (obviously not in practice) a PE firm should be able to hold an asset and generate a reliable return with dividend recaps, paying out FCF, etc. In conventional wisdom the value of the asset should be the PV of the cash flows, so in theory selling an asset vs holding for cash flows should be identical. The fact that PE is so reliant on an exit as the only way of making money just reiterates my point that valuations are insane and the ecosystem is unsustainable

Nov 18, 2021 - 11:43pm

Ah, i see you have naturally stumbled upon the importance of fund vintage!

Life is more than dollars
  • 1
Nov 26, 2021 - 2:07pm

While this is a real issue, it's much worse in tech (where it's much harder to value companies given most are unprofitable and have insane growth rates). I work as a generalist and partner with a lot of PE firms and PE firms do actually do the diligence and look to put a fair value on the company. Multiples are going up, but all the deals that we've done in the last few months have underwritten a multiple contraction by exit. You have to remember too that the LPs for all of these firms can have overlaps, but not perfect, so the PE firms do want to acquire assets at real values since real money is changing hands (as well as impacting their own carry).

Also knowing what the exit is going to be is important. PE firms have defined fund lives and are essentially forced to sell off assets by the end (ignoring continuation vehicles which is mostly a recent trend), so of course you would want to know how you would be able to sell it, since that directly impacts your underwriting. Similar to how most people in IB have an exit in mind before they even join.   

It is true that so much dry powder is making this issue much worse and megafunds do just look like they're playing musical chairs (but also remember that a decent amount of MF exits are IPOs, not another sponsor sale (which again, has been changing recently with these mega club deals).

Nov 29, 2021 - 2:01pm

MM PE analyst here, I think it depends on fund size. It is more difficult to sell KKR size companies to strategic buyers than MM size companies. Then you also get the fund lifecycle, if you have a deadline for exiting a fund (payday), you might simply target other PE companies funds with other focus (e.g. growth turns into dividend etc.). The exit strategy is almost always skeched way before the acquisition, and strategic buyers or IPOs are generally preffered to PE funds.

Nov 29, 2021 - 4:49pm

I think PE asset prices are by nature cyclical – so if assets are over valued now, there may be a bubble caused by a number of reasons. This doesn't mean the asset class has no long term future. Prices should correct themselves, returns will falter and the cycle will repeat. There have been many times in history that are at least a bit comparable when assets generally or in a particular industry have been overvalued and have had to be corrected. I wouldn't necessarily base your career move on this

Nov 30, 2021 - 10:11pm

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