Over the past couple of months, two high-profile investors—and a veritable horde of Twitter commentators—have likened some parts of private equity to a Ponzi or pyramid scheme.
Vincent Mortier, CIO of asset manager Amundi, was the first to make the controversial comparison, citing an increase in PE firms selling companies to each other—otherwise known as secondary buyouts. He also warned of the opaque nature of the private markets, which can make it difficult to assess the true value of assets.
Mortier said: “You know you can sell [a company] to another private equity firm for 20 or 30 times [that company’s] earnings. That’s why you can talk about a Ponzi. It’s a circular thing.” He added later that there would undoubtedly be casualties, but maybe not for another four or five years.
While Mortier didn’t say what kind of casualties, he may mean that, eventually, there will be no one left willing to buy overpriced assets, resulting in poor returns, or even losses, for investors and potentially company failures.
A few months later, Mikkel Svenstrup, CIO of Danish pension fund ATP, warned that PE was in danger of becoming a pyramid scheme, also due to an increase in secondary buyout activity. Svenstrup further noted that the proliferation of continuation funds—which allow GPs to move an existing asset, or multiple assets, into a special purpose vehicle in order to keep hold of their best-performing assets—is another red flag.
“This is the start of, potentially, I’m saying ‘potentially,’ a pyramid scheme,” Svenstrup told the Financial Times. “Everybody’s selling to each other … Banks are lending against it. These are the concerns I’ve been sharing.”
Put simply, a Ponzi scheme is a fraud where early investors are paid with funds obtained from later investors. This could mean investing in a company or technology that has no intrinsic value on the promise of substantial returns, and ending up with nothing.
While investing in PE always carries the risk of losses, any comparison to the above is flawed.
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Mortier and Svenstrup’s fears over a rush of secondary buyouts seem to me a tad overblown. Sure, this year has seen some particularly large deals, including Bain Capital and Hellman & Friedman‘s $17 billion acquisition of Athenahealth from Veritas Capital and Evergreen Coast Capital. But PitchBook data shows that secondary buyouts accounted for less than 31% of exits this year in terms of volume; sales to corporations are still the preferred method.
These figures are in line with previous years, so concerns of a sudden increase in secondary buyouts don’t appear to be supported.
Furthermore, PE’s main strategy for buying companies, whether it be from each other or another party, remains buy-and-build, i.e. firms acquiring and adding smaller companies to an existing platform. Unlike a Ponzi scheme, where the investment remains static and therefore produces no returns, PE investors are expanding their portfolio companies’ operations to generate value and increase returns.
In the same vein, there has been an uptick in the use of continuation funds, but they’re still not exactly run of the mill.
The purpose of these vehicles is to allow GPs to hold onto assets they feel are undervalued at the end of a fund’s life cycle in order to achieve a better exit when circumstances are more favorable. This can be particularly useful when market conditions become more challenging due to macroeconomic factors.
Continuation funds are designed to give GPs and their LPs a chance at better returns, although it may not always work out that way. But, perhaps more importantly, they give LPs an opportunity to exit.
If a PE firm were to sell an asset from one standard fund to another, then there’s necessarily an imbalance. Does the firm prioritize the original fund by selling at a higher price or the second by buying at a lower cost? Either way, one set of LPs is going to lose. But with a continuation fund, LPs who no longer wish to be involved can exit instead of being stuck in a loop.
Mortier does have a point when it comes to valuing PE assets. Publicly listed companies’ market caps can be tracked in real time and are more susceptible to the fluctuations of the stock market and macroeconomics. On the other hand, PE firms don’t have to disclose the value of assets and can maintain a price tag—at least to outsiders—even while the world crashes down around them. Comparables in the public markets are often used to determine a private asset’s value, but it’s not always a true reflection.
For now, and perhaps the foreseeable future, the era of cheap money and rising valuations is over, and many PE firms will have to mark down assets if they haven’t already. So Mortier is right that there will be casualties among overvalued companies as new economic realities set in.
No one is pretending that private equity is without risk, and there have been many high-profile failures over the years—as there have in every other asset class. And, of course, there are bad actors who will try to inflate valuations and manipulate returns, perhaps even a couple of Ponzi schemes (Dubai-based firm The Abraaj Group comes to mind).
But sweeping statements about an entire industry can be of limited value. Private equity may have its faults, including a lack of transparency, but a Ponzi scheme? I don’t think so.
Featured image by Chloe Ladwig/PitchBook News