The Troubling Trend of Circular Deals in Private Equity: A Closer Look

Introduction

The landscape of private equity is shifting, revealing a worrying trend that has raised eyebrows among investors and analysts alike. For these firms, the struggle to offload companies has led to a controversial workaround: selling companies to themselves through so-called continuation funds.

A Closer Look at Continuation Funds

These funds have emerged as a temporary solution to a pressing problem. With a backlog of over 31,000 unsold companies, many investment firms, such as Clearlake Capital, are turning to internal sales as a means to generate liquidity. Investors have expressed concerns that this method, while seemingly beneficial in the short term, may mask underlying weaknesses in the assets involved.

"Continuation vehicles are indicative of rot in private equity," states Marcus Frampton, chief investment officer of the Alaska Permanent Fund Corporation.

The Numbers Behind the Trend

Data from Evercore reveals that the market for continuation funds is burgeoning, growing from approximately $35 billion in 2019 to over $100 billion expected by the end of 2025. This dramatic increase speaks volumes about the industry's attempts to navigate through landmines of high interest rates and a distressed sales environment.

While the use of continuation funds presents itself as a pragmatic solution, some investors argue that the practice leads to inflated valuations and can risk deeper losses down the line. When a private equity firm acts as both buyer and seller, who truly benefits?

Case Studies: Lessons Learned

Take the case of Wheel Pros, an auto accessories retailer. Clearlake Capital sold Wheel Pros to its own continuation fund, inflating its valuation to $2.3 billion, four times the initial purchase price just three years earlier. Although this maneuver seemed advantageous at the time, two years later, Wheel Pros filed for bankruptcy. Investors across various pension funds were left with enormous losses, illustrating the precariousness of this approach.

Similarly, Platinum Equity's dealings with United Site Services showcased the risks associated with continuation funds. Once touted as a significant success, the company now faces severe financial challenges, indicating that what may initially appear as a win-win solution can quickly turn into a nightmare.

Concerns Over Transparency

The concern isn't just about inflated valuations but also about transparency. Critics of continuation funds argue that too often, necessary due diligence is bypassed. For instance, the recent lawsuit against Energy & Minerals Group highlights potential conflicts of interest, emphasizing the delicate balance between investor assurance and firm profit.

The Future of Private Equity?

As the lines blur between investment opportunities and potential pitfalls, the future of private equity is uncertain. While firms like Clearlake advocate for the use of continuation funds as a logical response to market pressures, many in the investment community are urging for stricter regulations to prevent conflicts of interest.

"The trend toward circular transactions is a troubling sign of an industry in need of deeper scrutiny," asserts Scott Ramsower, from the Teacher Retirement System of Texas.

Conclusion

As we dissect these developments further, it becomes clearer that the strategies employed by private equity firms today may not just be transitional fixes but symptomatic of a system that requires thorough re-evaluation. The implications of these circular deals extend beyond the firms themselves; they have a direct impact on the investors who put their trust—and their capital—on the line.