Buyout firms recycle investments between funds

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London-based mid-market private equity firm Sovereign Capital has used money from its latest fund, Fund VI, to buy a company it already owned in order to keep exposure to the growing business.

Sovereign first invested in the British and Irish Modern Music Institute in 2010, using capital from Fund II, a £275 million fund that it raised in 2005. The fund, which has a 10 year lifespan, has been extended by one year to allow Sovereign to sell its remaining investments.

In response to certain investor requests to hold the business for longer, Sovereign transferred the company from Fund II to Fund IV, a £395 million vehicle it raised in August 2014, the firm’s investor relations director Virginia Doble confirmed.

“Given the numerous opportunities to further develop the group, Sovereign was keen to continue to partner with BIMM and its strong management team,” she said.

“There was a process, so the price was properly tested in the market.”

She added that Sovereign does not plan to do similar deals on a regular basis.

Two M&A lawyers told FN’s sister publication Private Equity News that several other similar deal processes are ongoing, in which buyout firms try to transfer good-performing assets from one fund to another fund.

The lifespan of a private equity fund can disrupt a good investment, a person familiar with Sovereign’s investment said, who added: “When you have a fantastic asset it is logical to keep hold of it.”

A “forced sale” is one of the limitations of the private equity fund structure, according to Peter Keehn, global head of private equity at Allstate Investments, the $ 72 billion investment manager for US-based Allstate Insurance Company.

He said: “Something artificial – either the end of a fund life or the need to raise a new fund – means the manager is bringing the asset to market before it would be the natural time to do that.”

Moving assets between funds could be one solution to this. The biggest concern for investors, however, is whether the company is sold at the right price.

Firms that explore such transfers need to get a third-party valuation as well as consent from the advisory board of both funds, according to Keehn.

He said: “The challenge is that the manager’s duty in the first fund is to sell at the highest price, while the manager’s duty in the second fund is essentially to buy at the lowest price. There’s an inherent conflict there.”

Benjamin Alt, executive director at Swiss fund of funds Adveq, agreed that the biggest question is how to establish the fair value of the company. However, he added that “if the company is great and the firm’s funds are growing in size, then it can work well”.

Jean-François Le Ruyet, a partner at Quilvest Private Equity, said he is cautious about these deals. “Sometimes [the firms looking to buy assets from within their portfolios] don’t have a fresh eye on the company and lack new imagination of what to do with the business,” he said.

What’s more, if investors have invested in both funds, profits will “leak out of the deal” because investors may end up paying carried interest and taxes before owning the asset for the second time, Keehn added.

Paul Newsome, head of investment management within the private equity team at Swiss asset management firm Unigestion said that although it is difficult to pinpoint the drivers of these deals, high prices might be one potential driver.

“If a GP has to pay 13 times Ebitda for a company, then they would rather buy a company they know extremely well,” he said.

When one undisclosed US fund manager, which Unigestion had invested in, transferred a company from one fund to another fund last year, Unigestion demanded that the firm did not pay itself profits on the deal, Newsome said.

“We requested that they reinvest their carried interest from the sale into the company, so there was no leakage,” he said.

He said that after it did extensive due diligence, Unigestion agreed with the valuation and ended up co-investing in the deal, but said that “nevertheless, our starting point on such deals is certainly one of scepticism”.

He added that there might be a peak of these deals this year or next year “because of where we are in the cycle”. However, the moment one of these deals blows up, he warned “there will be a reverse trend”.

Additional reporting by William Louch

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