89 points by cwwc
7 days ago
To play devil's advocate, the reason a private equity firm should use a continuation is that it wants to hold an asset past the fund's 10-year life because the asset is continuing to perform very well. 10 years ago, many private equity firms felt heartburn from letting big software winners go after 5 years because that's the typical fund cycle.
In reality, LPs and GPs would have been better off reliably holding the same growing asset for 15-20 years as the company went from $10M in EBITDA to $250M. Why take a 3x in 5 years when you can get a 25x in 15 years? The annual compounding works out to be roughly the same. The only issue is your fund structure so you trade it amongst yourself every 3-5 years at a 3-4x mark that makes you look good to your investors. The growth is usually there so it is not a lie though liberty may be taken with multiples which expanded rapidly over the last decade.
This phenomenon has been used aggressively, perhaps too aggressively, in software and particularly software roll-ups where you can comfortably compound 20-30% EBITDA growth annually between 10-15% organic growth (half or more of which is just price increases) and an aggressive M&A strategy that drives higher margins.
That said, this article is raising an early and important alarm bell to the broader public, who have a vested interest because their pensions are invested in these firms, that certain firms may be using it too aggressively. When I scan the broader PE landscape, the firm that has used it to the most success is Clearlake Capital. I don't have insight into their whole portfolio but have heard criticisms that they overuse it. Or that their is incestuous trading of assets between them, TA Associates, Hg, Insight Partners, FP, Thoma, and a handful of others.
> The only issue is your fund structure so you trade it amongst yourself every 3-5 years at a 3-4x mark that makes you look good to your investors. The growth is usually there so it is not a lie though liberty may be taken with multiples which expanded rapidly over the last decade.
The problem is that it's not possible to actually say that. Because the valuation never gets tested against the market you're just marking your own homework. It's a strong protection of these closed end funds that at some point you do actually have to provide the return on investment.
To put it another way - who needs to engage in this, well performing funds that are beating their expectations and making big returns, or poor performing funds who need to come up with creative ways to disguise their bad investment decisions.
> Why take a 3x in 5 years when you can get a 25x in 15 years?
3x in 5 years is equivalent to 27x in 15 years.
Obviously it's not that simple in practice but it's not like it's easy to predict growth over a 15 year period.
The issue here is the lack of opportunities. You have a finite number of bins to place your money in. If you find a "winner," there is no necessarily refresh to get new winners.
After some amount invested that likely most people will never see one has a hard time finding suitable places to reinvest -- that is experienced by eg the renessaince fund, Warren buffet etc. Or of course you can inflate the public or private market
"roughly" is in the next sentence...and if we are being so pedantic "equivalent" is the wrong phrasing for everyone except like 10 people.
> "equivalent" is the wrong phrasing
A 15-year period is 3 times longer than a 5-year period.
5x3 = 15
Compounding the 3x return, for 3 times:
3^3 = 27
They are exactly, mathematically equivalent.
But of course there's no way to predict that the growth rate will stay the same. Logistic functions look like exponentials, until they suddenly don't (market saturation).
The IRR is equivalent. You can't eat(spend) IRR.
The NPV is not equivalent (unless you happen to have a cost of capital = 25%... like about 10 people). The cash on cash is not equivalent. Every person on planet earth will take the 15 year compounding (again except the 10 or so..).... hence they are not equivalent. When returns are high, investors are not indifferent to time horizon. Longer is better. To make it extremely clear - would you prefer IRR of 50% for 1 minute or 10 years?
The only statement which is precise enough is "the IRR is equivalent". Anyone can be pedantic, it rarely helps.
You are right. Only in a zero-interest-rate environment are they "equivalent" WRT NPV. If you can safely get high returns, then you have to discount them.
They are equivalent NPV wise only when the cost of capital is 25%. Cost of capital is a fuzzy concept and different folks have different numbers based on all kinds of things (despite the precise numbers put in spreadsheets). From a practical perspective they will almost never be NPV equivalent.
I'd imagine that every acquisition comes with a non-negligible acquisition cost, which should be baked into the calculation.
Less companies held over a longer time would mean less acquisition costs, while more companies held over a shorter time would mean more acquisition costs.
> When I scan the broader PE landscape
How do you do that? What's the source for getting to know what's going on with PE firms and their funds?
IRR is higher with 3x over 5 years than 25x over 15 years. More fees in the first example
Yeah, this is what happens when institutional investors decide to throw their money into poorly regulated private equity vehicles.
If only we had some mechanism whereby companies' shares could be listed somewhere public, and people could buy and sell them to determine what a fair price for these companies would be! Oh, better yet - we could have a regulatory body that could prevent companies from selling the same asset back and forth to themselves to inflate the price. Crazy, right?
Oh come on, a lot of good companies stay private bc the SEC makes it a pain in the ass (and expensive) to be public. And it's making it worse with stupid shit like ESG reporting or SOX compliance they just keep adding. And these days you run the risk of some social justice warrior micro fund buying 2 shares going to CALSTRS or whatever and running a proxy fight. I would not want to take a company public these days and I don't see problems with companies staying privately held.
PE LPs are all accredited and know what they're doing, they're betting on a greater fool buying for a higher multiple later bc it worked for the past years, multiples kept rising. Blame the fed, blame congress, blame stupid people who somehow got money. Now people complain bc there's a downturn. I don't know how people are unironically painting them as victims.
> And these days you run the risk of some social justice warrior micro fund buying 2 shares going to CALSTRS or whatever and running a proxy fight. I would not want to take a company public these days and I don't see problems with companies staying privately held.
If you’ve reached the size of being a public company, lawsuits are a Tuesday. If the flavor of the frivolous is driving executives and investors decision making, then it’s a cultural choice.
> Oh come on, a lot of good companies stay private bc the SEC makes it a pain in the ass (and expensive) to be public. And it's making it worse with stupid shit like ESG reporting or SOX compliance they just keep adding.
It does make it a pain but it also increases the trust investment has in your company to not do things like trade assets between two vehicles you control with no proof that it’s not to your benefit
Generally agree that these aren’t victims though. To borrow a term from Eve, it seems like they decide to venture into null sec space and are surprised they could get hurt
It used to be more manageable to go public before becoming the size where lawsuits and legal fees mean nothing, is the point.
Proxy fights are worse than lawsuits. Lawsuits cost money and waste lawyers time, but proxy fights waste the board and executives time and distract them from running the company. Also if you want more companies to be public than this is a bad argument.
Also these deals arent suffering from a "lack of transparency". The LPs know exactly what they're doing, they're literally marketed as continuation funds. You really can't complain about high net worth individuals or institutional investors getting "taken advantage of" like you can with some random guy investing his 401k in the public markets. Smh.
SOX compliance is a huge PITA but has driven engineering changes that have made the orgs Ive worked at much more secure.
In particular, rules that require code reviews, auditing around production deployments, regular patching and exercising backup/recovery mechanisms have all made the systems Ive worked on operationally resilient.
It does depend on what kind of expertise your compliance team has (or the 3rd party tool you might use). But followed in spirit, SOX regulations have probably been a net benefit.
I thought SOX was mostly financial. What you’re saying here sounds more like SOC. are they connected?
You can think of SOX as RFC and SOC2 as an implementation of it.
SOC 2 is the bit that changes how software development is done, and has literally nothing to do with SOX, even according to that article.
There is literally 0 requirement to implement SOC2 for SOX. They are not related at all aside from that a lot of organizations do both. I'm kinda curious now where you got this idea?
> PE LPs are all accredited and know what they're doing
Lol. Who’s accrediting them? 9/10 can’t make a 3-statement that foots.
An accredited investor is one who has a certain amount of wealth, apart from their main residence. The SEC lays down the definition.
You need to be an accredited investor to invest, as an individual, in hedge funds, private equity, and some other similar things.
Yeah, hence the joke.
Kim Kardashian is an accredited investor.
Lmao true for some of the AM guys I've met. But no it's an SEC designation of having a lot of money (so you aren't broke if you lose it) or proven knowledge (new rule so finance professionals who theoretically know what they're doing can invest).
A friend of mine also became an "accredited" investor through the simple expedient of lying on the form. Many financial services companies don't bother to verify investor income and assets.
It's not a matter of bothering, the ones that don't do general solicitation or are less than $150mm AUM don't have to actually verify. Which is good because LPs get mad when you ask them for tax returns.
Yeah hence the joke.
Kim Kardashian is an accredited investor
You’re completely ignoring the capital markets differences between public and private assets. Companies require capital to operate, capital has a cost, the cost is different depending on which capital market you fundraise from.
The size of these markets are different, their demands on returns and time horizons are different. This provides a much better variety of capital choices for companies searching for capital. If only the public equity market existed, the capital market would be very inefficient. This is microeconomics 101, increase choice/variety to most efficiently meet demand without creating deadweight loss.
Institutional investors often actually like being able to invest in assets that aren't subject to public market fluctuations based on speculation, sentiment, derivatives, proxy disputes, where any share transactions are strictly controlled and repurchase rights themselves are tightly bartered between various share classes.
Ultimately, the kind of wash sale you're talking about only applies when sophisticated accredited investors pump the price and dump to unaccredited unsophisticated investors. Institutional investors must know better, or (to the benefit of other institutions), they don't remain fit enough to be an accredited institutional investor for very long.
Regulators lie downstream from, and are often directly captured by this sort of jockeying for power between large institutional investors and their turf wars (SEC/CFTC -> private sector financial services/banking pipeline). So regulation isn't always an effective answer for these kinds of incentive problems.
The private markets are very liquid for quality assets, you don’t need to go public for that, and the sec would not prevent these actions, their requirements would be comprehensive disclosure of the conflicts, not prohibition
By rough approximation, it's at least $1M per year in purely excess G&A costs to meet public company regulatory requirements. And then there's the constant management distraction of quarterly earnings song & dances, disclosing key strategic matters that might be better left private, governance requirements, increased surface area for lawsuits, wallstreet manipulations, etc.
Being private can make the companies much more nimble -- especially if they actually have rigor & profits rather than requiring perpetual shareholder subsidization of "growth."
TLDR: Being public (even absent Sarbanes Oxley) isn't a panacea.
It seems like there are two issues:
1. The GP arranges for one of its funds to buy from another fund. These funds likely have a different mix of LPs. Because both funds are represented by the same GP, there's no competitive negotiation, and the valuation chosen may benefit one group of LPs (and possibly the GP) at the expense of the other.
2. Such a transaction can increase the total fees earned by the GP, even without additional effort or additional value being created or realized.
>a transaction can increase the total fees earned by the GP
PE isn't like a stock brokerage. No transaction fees.
Depending on fee structure it may push future fees up since it rebases cost though. Less relevant if commit based
Most continuation funds I've seen skip the investment period fees and drop straight to the reduced fees afterward so arguably they're charging less than a typical one (which makes sense bc they aren't doing the initial investment but still)
> PE isn't like a stock brokerage. No transaction fees.
Yeah I wasn't clear. I meant that the fund could continue getting fees for longer, on the same investment. Collegeburner's sibling comment explains it better, and explains why my point probably doesn't apply in most cases.
Except LPs aren't stupid. They probably won't keep going with this if it doesn't pay off. They're not Joe Boomer deciding he needs to diversify from his 60/40 blue chips and bonds, they're high net worth individuals and institutional investors who are either 1. Being stupid and getting what's coming to them or 2. Getting greedy and getting what's coming to them.
The rationale that is usually given to LPs to make them go along is that the time to exit is not right, but the one fund that currently owns the interest is getting long in the tooth, so they need to move the interest to the newer vintage year fund. They spin it as, we thought it was a good investment before, and we think it is an even better investment now, so we want to hold onto it. But we still need to wind down the old fund.
It's a nightmare from a valuation standpoint, because while many LPs may well be invested in both funds, making it a wash, some are not. The LPs that invest in both funds sign a check to fund the investment in the new fund, and then get the money back as the older vintage is winding down. The investment just essentially gets rolled forward. The investors who are only in the new fund are cashing out the previous investors, so this is much more of a concern. But they are new and still usually riding the feeling of wow, they let me invest in this awesome fund. PE firms are really good at creating an aura of exclusivity and luxury.
A rolling loan gathers no loss. So long as the music keeps playing, valuations can be whatever number you can get your auditor to agree to. Nice dinners and event tickets for your audit partner can help with that.
Except I think in the case where I’m an LP in both funds I potentially pay an incentive fee in Old fund even if the value defines dramatically in new fund, so still could be bad for me
This is true, it cashes out the carried interest as well, so if the new fund closes with a lower valuation for that investment, the investor was screwed out of more carried interest than should have been paid.
It's not a "right time" argument, I've seen people place these and they're usually pitched that this is a "real winner" and there's a bunch more growth left if they stay invested. That's why they're moving towards single-company funds. And sometimes they're right tbh.
And tbh there would be some other LPs cashing out the previous investors if the company was sold normally. The only LPs who take this risk are the ones who buy into the new fund. And if they're worried they should just check the GP commit, if it's thin then obv they're just pulling fees so don't invest. Some of the continuation funds the GPs actually believe they have a really good investment and they increase their commit as a %.
And the increasing valuations you describe are literally the same as the public markets the past few years. No bribing audit partners required.
LPs are usually pension plans, endowments, or family offices. The stewards of these have different incentives than the ones that are tied to the capital.
LPs don't have a say.
Their ability to withdraw/redemption is often heavily constricted too.
(I’m not making an opinion on GP behavior yet)
Uhh yeah they do. Maybe it's technically the GPs decision but I have watched GPs get their asses chewed by LPs and make a different call after those kinds of meetings.
More importantly literally all LPs have to do is not invest in the continuation fund. It costs them 0 money extra to close out their position in the old fund and leave. Continuation funds are 100% optional.
Also IMHO continuation funds can be useful if a PE firm thinks it has a real winner. It's harder than you think to find good places to place a lot of money so it will grow so I can understand why LPs might go for it in some cases.
It's kind of funny to me that this stuff happens. You can dress it up however you want, but it's fundamentally just putting these PE groups in an unethical position. You can't with a straight face say that you're getting the best price for both the investors you're selling it from and the investors you're buying it for. Firstly, there is no way you can correctly value these companies when you're selling them between your own funds. Just laying aside the mechanisms of how this is done, anyone investing in those groups should be taking a long hard look at whether you want people this unethical to manage your money.
And of course that doesn't even start to consider the fact that by doing this the PE companies get to mark their own homework, fraudulently pumping valuations by self-dealing safe in the knowledge their valuations don't need to be tested against the public markets.
This just seems like the exact same sort of absurd regulatory loophole that saw SPACS explode and then implode over 18 months. The fact that these firms have been forced to start chasing this style of innovation is not a good sign for the core business.
Tangentially, I had dealings with The Access Group when I was head of finance at a hospitality group.
Access were full of lies. They bought up many category leaders for hospitality software, and tried to sell a single solution that then didn't really work together.
Their sales teams were aggressive, but their solution "made sense" to other decision makers even though Access couldn't really deliver.
Sounds like a mirror of wash trading of the crypto world.
If I bought a painting and sold it to myself for more money, I'd get investigated for money laundering. These people are taking things with no established market values and self-dealing with them. It reeks of fraud and misdirection.
This reminds me in no small way of Max Fosh in his real-yet-satirical take https://youtu.be/iHfJRON3b-w
Can family offices, idk maybe one with a big Roth IRA, lever this?
You wouldn't "lever" this any different from how you would another PE fund. Yes accredited investors can invest in a PE fund with a Roth IRA. Just like any other PE fund they can invest in a continuation. But TBH I'd be careful before you do that, a few of the ones I've seen are good but a lot of these aren't really that great. Though that's a lot of PE these days with too much $ chasing too few companies.
Family Offices and Roth IRAs don't exist in the same universe.
A family office is simply a team of lawyers/financiers who manage an individual/family's money, rather than outside money.
A Roth IRA is a just a bucket with rules about how money can go in and out.
There is no reason they are mutually exclusive. Additionally, Roth IRAs can be self-directed which means they can use whatever exotic investment they choose, including private equity.
They can and do exist in the same world.
For funding, people with self-directed Roth accounts can pump $50,000-$60,000 into them via the annual 401k contributions
(this is the slightly obscure higher annual limit when you can make employer contributions on your own behalf)
and then get a couple 3,800% gains in some private equity investments tax free (a percentage from the article), and go from there
Any retirement account can just be a distinct limited partner in the family office or fund
Is it true being acquired by PE is a death sentence for engineers at a company? With P.E introducing cuts & offshoring immediately to improve their bottomline
Tech guy who advises PE here(overseen 400+ PE deals, half of which are software companies).
The "financial engineering" trope with PE is largely in the large cap space ($1B+ EV). Most middle market PE is all about value creation.
Note - there are some notorious "death sentence" firms in the middle market...I won't name names but if you dig deep enough you'll see some PE shops (there's only 2 I can actually name off hand) that buy small tech cos and send all of the dev overseas.
There are growth-oriented PE firms, there are income-oriented PE firms. Completely depends on what kind bought you.
Nah. PE gets a bad reputation for asset stripping shit but that's not most of it. The LBO guys generally understand they need to maintain software for the business to cashflow and make payments and the growth equity funds obv want the business to improve. Another positive is PE has longer hold periods and less liquidity, public markets have a lot more pressure of "oh shit the share price is down 15% start firing and doing buybacks". And yeah there are distressed guys who will go in and gut a place but tbh they don't usually get involved unless something bad is coming regardless. Like if a distressed fund is trying to acquire your company somebody about to get laid off regardless of whether they buy it or not.
Totally depends. I declined to stay as part of a PE acquisition once as a middle manager, but a solid 6 figure pay day to stay a few years was promised. Just didn’t interest me.
Death sentence for user experience.