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What’s a fair price when you are selling something to yourself? On Wall Street, that’s not a trick question.

A growing number of private equity firms are establishing new funds to buy portfolio companies from funds they already control. With the buyer and seller each an entity controlled by the same private equity firm, scrutiny is growing over how they price such deals.

“Transactions must be done at fair value and this must be sufficiently mitigated to make sure everybody feels good about the deal being done,” said Brian Rodde, managing partner at Makena Capital, a private equity investor.

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In a traditional private equity transaction, investors will give a private equity fund money to invest in a portfolio of companies with the expectation that they will get their money back, plus profit, once those companies have been sold to outside buyers, usually in a 5-7 year timeframe.

The coronavirus pandemic initially disrupted private equity funds’ ability to exit companies and return funds to investors because would-be buyers were wary of deals. Raising new funds to buy the firms allowed private equity funds to hang on to good companies, keep charging investors lucrative management fees and give cash back to those investors who didn’t want to wait for their return.

The value of transactions involving buyout firms acquiring companies from themselves reached a record $21.8 billion in 2020, accounting for 87% of all deals in the secondary market initiated by private equity firms, according to fund placement agent Campbell Lutyens. That is up from $17 billion in 2019, when they accounted for 68% of all deals in the secondary market for private equity fund stakes.

A new record may be hit this year, as deal volume in the first quarter reached $15 billion, up from $7 billion from a year ago, according to a Citigroup Inc estimate. Industry executives say these deals are becoming more popular because as market fears around the pandemic recede and record levels of mergers and acquisitions ensue, some fund investors want to cash out to avail of new opportunities.

The risk for investors looking to exit is that they may be forfeiting the opportunity for extra profit by selling too early or at too low a price, while those buying may be overpaying for assets that may not deliver on promised returns.

Existing investors can, however, stick with the asset if they believe there is more value to be had in the future.

“Investors generally have the option to roll their exposure if they believe there is more upside on a go-forward basis,” Orcun Unlu, Citigroup’s global head of private funds, said.

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Private equity funds have an incentive to hold on to good companies because increased competition for new acquisitions has driven up valuations, meaning it is expensive for them to go hunting anew. It is also risky; there is no guarantee that the next company they buy will be as successful as the one they own now.

“There was an expected duration for an exit for some of these (fund managers) on certain transactions and that got pushed out,” said Chris Perriello, co-head of secondary fund investments at AlpInvest Partners, a division of buyout firm Carlyle Group Inc.

“For the most part, they have been companies that have done very well and there’s some sort of value creation story.”

FINDING A FAIR PRICE

To acquire a company already owned by investors in one of its funds, a private equity firm raises a so-called continuation fund, which may include some of the original investors from the old fund as well as new investors.

The investors are the ultimate owners of the portfolio companies, paying private equity firms fees for managing the assets and their performance.

Buyout firms Ares Management Corp, Hellman & Friedman LLC and Clearlake Capital are among recent users of so-called continuation funds that are raised to buy portfolio companies from funds they manage, sources told Reuters.

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Ares, Hellman & Friedman and Clearlake Capital declined to comment.

The continuation fund can invest in a number of portfolio companies but funds focused on single assets have seen the biggest growth in recent years, accounting for $14 billion in assets at the end of last year, compared to zero in 2017, according to data from Credit Suisse.

With such deals growing in popularity, investors are seeking greater detail on how valuations are reached.

They do this by setting up independent committees to vet whether private equity firms have any entrenched conflicts of interest and the profitability of any proposed deal.

To further reassure investors that the price agreed reflects fair market value, private equity funds often run auctions, inviting secondary fund firms, which specialize in investing in second-hand private equity assets, to submit bids.

For example, when buyout firm Energy Capital Partners raised a $1.2 billion continuation fund this year to buy a 50% stake in U.S. renewable power and storage developer Terra-Gen from one of its older funds, it agreed on a price following a bid for the stake from Blackstone Group Inc’s secondary funds division.

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The price matched the amount Energy Capital Partners raised when it sold 50% of the company months earlier to investment firm First Sentier Investors.

Blackstone ended up as a major investor in the continuation fund, which attracted 20% of the investors in the original buyout fund holding the Terra-Gen stake, Energy Capital Partners founder Doug Kimmelman said in an interview.

But the auction process does not assuage all investor concerns. Participants could end up investing alongside the private equity fund or in their continuation funds. Potential acquirers of the entire company, who have more of a reason to compete on price, are not always invited.

This can make some investors wary of the process, said David Layton, chief executive officer of Partners Group Holding AG , a private equity firm with a big secondary fund division that invests in continuation fund deals. “There can be misalignment of interest between parties and I think this has to be navigated very carefully,” Layton said.

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