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Industry pioneers like KKR, Blackstone and Apollo Global Management have grown into much more diversified businesses that resemble more of an asset manager than a traditional buyout group.Brendan McDermid/Reuters

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Is the private equity industry constructing a giant pyramid scheme that could be bad for business? A number of influential investment managers in Europe seem to believe that.

Mikkel Svenstrup, chief investment officer at ATP Livslang Penison, Denmark’s largest pension fund, warned that the increasingly common practice of private equity groups selling companies to each other, including to newer funds controlled by the same buyout firm, is concerning.

Amundi Asset Management’s chief investment officer Vincent Mortier said more or less the same in June: “Some parts of private equity look like a pyramid scheme in a way. ...You know you can sell to another private equity firm for 20 or 30 times earnings. ... It’s a circular thing.”

Such criticism has risen on the back of the private equity industry’s boom in so-called continuation funds, a new level of “creative” and lucrative financial engineering even for a sector run by top financial wizards.

This is where a buyout group sells an asset it has owned for several years to a new fund it has more recently raised. It is an evolution of the pass-the-parcel deals in which one private equity group sold an asset to another in the secondary market.

The traditional image of buyout firms may have once been all about taking poorly performing listed companies private, loading them up with debt and carrying out brutal restructurings before making a profit around five years later by selling them – either to public markets or a corporate buyer. Or possibly rolling a series of acquisitions of companies up into bigger entities capable of dominating a single industry.

Those strategies still exist but industry pioneers like KKR & Co. Inc., Blackstone Inc. and Apollo Global Management have grown into much more diversified businesses that resemble more of an asset manager than a traditional buyout group. For these publicly traded, private equity players, the name of the game is adding assets under management.

The more assets they gather, the more fees they take from their investors. Shareholders in the listed groups certainly value the consistency of such management fees far higher than the more sporadic performance fee-based profits earned from deals.

So the private equity groups look to hold on to assets for longer. Hence the incentives for continuation deals. Why give up a great company offering a steady cash flow to sell to a competitor? A particular fund nearing the end of a finite life might have to divest, but another managed by the same private equity group might benefit. It is also a way for private equity groups to deploy some of the rivers of cash that have been committed to the sector in recent years.

The conflicts of interest involved in this should make fund investors nervous – i.e. is the acquiring fund paying too much, flattering the seller? Or is the old fund offloading a poor-quality asset, already milked by the private equity machine? But does all this make the industry a pyramid or a Ponzi scheme?

Well, some perspective. Some US$65-billion worth of deals were carried out this way last year, according to Raymond James’ Cebile Capital unit. So continuation deals are a rising part of the industry. However, those levels compare with US$656-billion of overall deals carried out by private equity year to date.

The bigger problem for private equity might be that it’s operating in an alternate reality.

For more than a decade, buyout groups binged on cheap debt, allowing them to buy up a tonne of assets while also raising huge sums of cash from investors desperate to boost returns. With interest rates rising, the problem is that a lot of what they now own may be worth less than what they paid for it. Given the private nature of these assets, it’s hard to tell how bad the losses might be.

What we do know is that since the start of the year, public markets have fallen sharply with the S&P 500 index down around 20 per cent and the Nasdaq Composite about 30 per cent. Private equity groups have been more cagey about their performance, but some portfolios at large buyout funds have been marked down by less than 10 per cent.

Some private equity groups might have outperformed but it is hard not to believe a crunch is coming – even for an industry traditionally insulated from the immediate accountability of public market valuation swings.

This will be painful for the many investors in private equity funds, like Mr. Svenstrup’s ATP, which has invested US$119-billion across 147 buyout funds, according to PitchBook Data Inc. Perhaps what private equity investors, like pension funds, should be thinking about is whether their decision in recent years to pump billions of dollars and euros into the industry was actually the right call in the first place given the lack of transparency in the sector.

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