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Analysis

How selling to yourself became private equity’s go-to deal

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Private equity firms have a new set of buyers for their portfolio companies: themselves.

Blackstone, EQT, BC Partners and Hellman & Friedman are among the buyout groups to have sold companies to funds that they control this year, or made plans to do so.

Although the model emerged before the pandemic, its use has been ignited by it. Lazard estimates that the value of such deals will hit $35bn this year, up from $7bn just four years ago.

With the crisis leaving corporate boards warier of doing deals, the private equity industry has found it harder to keep its simple promise to investors of selling portfolio companies to outside buyers after a set period of ownership.

“The immediate post-Covid recession caused declines in M&A markets and in the ability of [private equity firms] to exit those businesses by selling them or taking them public,” said Holcombe Green, global head of private capital at Lazard. “When traditional routes to exit are reduced, the owners start to look for an alternative.”

The transactions allow firms to hang on to good companies — an attractive prospect as the industry’s $2.5tn pile of unspent money drives up the competition for new acquisitions. They also provide a solution if a buyout fund nears the end of its ten-year life but has not yet sold its portfolio companies.

To execute them, a private equity firm creates a so-called continuation fund, finds investors to back it and then uses it to buy a portfolio company already owned by one of its other funds.

At the heart of the process are groups known as secondary funds, specialist asset managers that raise money from pension and sovereign wealth funds. They are ploughing more of their cash into continuation deals, partly in the hope of generating quicker returns than they would from a traditional 10-year private equity fund.

But as the trend gathers pace, its inherent tensions are drawing scrutiny.

Column chart of $bn showing total value of continuation fund deals

Industry executives say it can be a way of offloading struggling companies that rival buyout firms, trade buyers or public investors do not want. That can leave the interests of those investors backing the continuation vehicles rubbing up against that of the buyout firm selling a portfolio company back to itself.

“It’s either for really high quality businesses people want to keep, or it’s flaky businesses you can’t get rid of any other way,” said a senior dealmaker at a large European buyout group.

Some deals, for example, involve a bundle of companies that can include “a dog and a star”, according to a senior private equity dealmaker, because “if you’re just selling the dog, no one’s going to buy it.” 

One fund manager who invests in the vehicles said that investors simply have to be “pragmatic” about this. If a fund contains five companies of which “two are interesting and three are less interesting . . . you’re solving a problem for [the private equity firm] and you get access to the high-quality assets.”

The momentum behind these transactions — sometimes known as sidecar deals — is expected to build next year.

“I think every single private equity firm will consider doing something like this at some point,” said David Kamo, head of US private equity M&A at Goldman Sachs. “We as a firm are bullish on getting ourselves organised around it” by hiring specialists in the field, he said.

For a buyout firm, selling a portfolio company to itself is now an “option like selling to [another company] is, like an IPO or selling to a Spac,” said Mr Kamo.

Continuation vehicles: How it works

CapVest put French pharmaceuticals group Curium up for sale in what it hoped at the beginning of 2020 could be a €3bn deal. By mid-March that was in tatters as tumbling markets forced buyers, unsure about financing, to step back. CapVest pulled the process and this month completed a sale to a continuation fund that it controls

stage one

Original private equity fund: company or companies carved out

stage two

Advisers call secondary funds, present the private equity firm’s valuation of the company or companies to be placed in the continuation fund, and ask for bids

stage three

Secondary funds say how much they would commit to the new vehicle and at what valuation. They can also include terms on management fees and carried interest. Typically, if a deal needs $1bn of equity, two or three large funds would commit about $200m each

Stage four

Once a couple of large players have signed up, bookbuilding begins: advisers raise the rest of the money from smaller investors on the terms agreed by the bigger groups. In the $1bn example above, they may commit about $25m each

Stage five

Investors in the original fund can buy into the new vehicle or cash out. The private equity firm is expected to keep some of its own money in the new fund too 

stage six

Company or companies transferred to new fund

And with swaths of the government bond market offering negligible returns, money is pouring into such deals. Pension funds have designated $25bn for such deals for 2021, up from $14bn this year and less than $8bn in 2019, Cebile Capital estimates.

Ardian and Lexington, two of the largest secondary funds, have raised $19bn and $14bn respectively for funds whose remit includes such deals. Goldman Sachs Asset Management could allocate about half of its $10bn secondaries fund to continuation vehicles, according to a person familiar with the matter.

As the financial firepower behind the deals swells, buyout groups are in a stronger position to set favourable terms.

Paying carried interest payments to private equity firm’s executives — a lucrative 20 per cent share of profits — in the previously small number of deals used to be a no-go, said Sunaina Sinha, founder of Cebile Capital. But it is now “standard,” she added. “If you look at the deals completed this year, in most of them they would’ve taken something home.”

Secondary funds raise record sums

Private equity firms benefit in other ways, said Eamon Devlin, a lawyer at MJ Hudson, an asset management consultancy. It can, for example, boost their total assets under management, a number many use to market themselves.

With the previously niche practice becoming more mainstream, so scrutiny is likely to grow. Establishing the price at which a portfolio company is sold remains the most contentious part of the process.

“At [its] heart is a conflict of interest,” Ms Sinha points out, as “the buyer and seller are both entities controlled by the same [private equity firm].” There is “nothing wrong” with such conflicts, she added, as long as a fair process takes place to agree a price. 

Some deals, such as Blackstone’s $14.6bn sale of property group BioMed Realty from one of its funds to another in October, involve a “go-shop” process in which bankers solicit higher bids for the portfolio company from outside rivals to see whether the continuation fund’s offer can be beaten.

But according to Ms Sinha and Mr Green, many such sales are not open to outsider bidders.

Investors “want to understand what the actual price discovery process was,” said Mr Devlin. “Some [private equity groups] are forthcoming with what the process was; some are not.”

Selling from the left hand to the right: some of the big deals this year

BioMed Realty: Blackstone sold the group, which leases real estate to life sciences companies, from one of its funds to another, in a $14.6bn deal in October. 

Curium: CapVest sold the French pharmaceuticals business to a new fund that it set up, after an external sale process that had been expected to value the company at about €3bn collapsed in March

IFS: EQT sold the enterprise software business from an older fund to a newer one for €3bn in July

Springer Nature: BC Partners is considering selling its stake in the business to a new fund that it would control, in a deal that may value it at about €6bn

Verisure and others: Hellman & Friedman is selling Verisure and two other companies from a fund it raised in 2011 to a new fund that it will control, three people familiar with the matter said



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Analysis

Investors rethink China strategy after regulatory shocks

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After four days of heavy selling in Chinese stocks, regulators in Beijing decided it was time to offer some reassurance to Wall Street. But some investors have still been left figuring out whether to double down or flee.

In a hastily arranged call on Wednesday evening, Chinese regulators told a dozen or so executives from global investors, heavy-hitting banks and Chinese financial groups not to fret about the shock overhaul of the country’s $100bn private tutoring industry. Investors should not worry about intervention to curtail profitmaking in other companies, they said. Rather, China remained committed to allowing companies to access capital markets. 

The message did not stick. Tech stocks in the country have wrapped up their worst month since the financial crisis of 2008. “Clearly there will be more [regulatory intervention] to come,” said one person briefed on the call. “That much was obvious to everyone.” 

Now, foreign investors in China have been left nursing huge losses, and anxious over where, after education, regulators might turn their attention next. They must decide whether the drop in stocks is an opportunity to double down on a fast-growing economy or a sign that unpredictable political risk outweighs potentially lucrative returns.

“The political risk factors of investing in China have grown exponentially in the past 18 months,” said Dominic Armstrong, chief executive of Horatius Capital, which runs a geopolitical investment fund. “People learned the hard way in Russia and they’re learning the hard way in China.” 

Line chart of Stock index performance year to date (%) showing China's tech crackdown hits foreign listings harder

Tough lesson

Following a leaked memo just over a week ago suggesting Beijing was planning to clamp down on education companies, the market sell-off was sharp.

It was led by a drop in education stocks that, according to one Gavekal analyst, made for “some of the most traumatic viewing since the charts of Lehman’s bonds”. TAL Education, Gaotu Techedu and New Oriental Education, which are listed in New York, all fell close to 60 per cent in the first hour of trading on July 23.

Further jitters came on Tuesday when Tencent, one of China’s biggest tech groups, announced its flagship WeChat social network had suspended user registrations as it upgraded security technology “to align with all relevant laws and regulations”. 

Nerves have pummelled Chinese tech groups listed in New York, taking the Nasdaq Golden Dragon China index down more than 20 per cent in July — the worst month since the global financial crisis. 

In Hong Kong, the Hang Seng Tech index fell almost 15 per cent, dragging the broader Hang Seng benchmark almost 9 per cent lower as Chinese internet giants Tencent and Alibaba fell 18 and 14 per cent, respectively. 

Big institutional investors have driven the selling, according to strategists at JPMorgan Chase. Meanwhile Ark Invest star manager Cathie Wood has also been slashing her China holdings. The $22.4bn Ark Innovation exchange-traded fund, which held an 8 per cent allocation to China shares in February, has now almost completely exited Chinese stocks, according to the company’s website.

But some have stepped in for a potential bargain. “We have been net buyers,” said a fund manager at a $15bn Asia-based asset manager. “It is unheard of to see these types of moves . . . You’ve got to buy them, unless you think the entire world is going to crash and burn.”

The new rules will ban companies that teach school curriculum subjects from accepting foreign investment © Costfoto/Barcroft Media via Getty

National objectives

The crackdown on education marks part of the Chinese Communist party’s attempts to address falling birth rates by removing some of the perceived financial obstacles to having children. The rules will ban companies that teach school curriculum subjects from making profits, raising capital or listing on stock exchanges worldwide, and from accepting foreign investment.

This sector is dominated by three large US-listed groups — TAL Education, New Oriental Education and Gaotu Techedu — which have enjoyed soaring valuations in recent years and drawn billions of dollars of backing from some of the world’s top investment firms such as BlackRock and Baillie Gifford.

Private rivals like Yuanfudao and Zuoyebang, which have held multibillion-dollar funding rounds in recent years, are backed by groups including Tencent, Sequoia, SoftBank’s Vision Fund and Jack Ma’s Yunfeng Capital.

The government intervention came shortly after anti-monopoly and data security measures against some of China’s largest tech companies. Last November the $37bn blockbuster initial public offering of Chinese payments group Ant was torpedoed by Beijing regulators, and its controlling shareholder — Alibaba founder Ma — disappeared from public view for several months.

In the past few months Beijing has also been expanding its influence in to the domestic online sector. In April it fined ecommerce group Alibaba $2.8bn for abusing its market dominance, and opened an antitrust investigation into Meituan, the takeaway delivery and lifestyle services platform. 

And earlier in July, Chinese regulators announced an investigation into possible data security breaches at Didi Chuxing, less than a month after the ride-hailing app raised more than $4bn in a New York listing. Its shares have dropped two-fifths since then.

Line chart of Performance of American depository receipts showing Once high-flying Chinese education stocks tumble back  to Earth

Baillie Gifford, the Edinburgh-based fund manager with £352bn in assets under management, is the second-largest shareholder in US-listed TAL and has made big bets on China’s tech sector.

“It’s not saying we like the geopolitics or the national politics or anything like that,” Baillie Gifford fund manager James Anderson told the Financial Times in June, referring to its decision to add exposure to China in recent years.

But potential gains are too compelling to ignore, he added, pointing to “the excitement we see around businesses, the ambition levels among Chinese entrepreneurs, and the relationships we can build with the individual companies”. 

Baillie Gifford declined to comment this week on the latest developments in China.

The new restrictions for private tutoring companies prohibit them from accepting foreign capital through “variable interest entity” structures — the model that many big Chinese tech firms have used to list abroad for two decades. The VIE structure, which allows global investors to get around controls on foreign ownership in some Chinese industries, has never been legally recognised in China, despite underpinning about $2tn of investments in companies like Alibaba and Pinduoduo on US markets. 

In response to Beijing’s restrictions on China-based companies raising capital offshore, on Friday the US Securities and Exchange Commission announced that China-based companies will have to disclose more about their structure and contacts with the Chinese government before listing in the US. 

“I worry that average investors may not realise that they hold stock in a shell company rather than a China-based operating company,” SEC chair Gary Gensler said in a statement.

Beijing has opened an antitrust investigation into Meituan, the takeaway delivery and lifestyle services platform © Yan Cong/Bloomberg

Widening crackdown?

The education crackdown sparked fears the VIE ban could be extended to other sectors.

Revoking the rights of Chinese companies to use VIEs is seen as China’s nuclear option. On Wednesday, Beijing regulators sought to reassure investors that it would not target VIEs more widely. But one Wall Street executive briefed on this week’s call with regulators said “it was more about what they didn’t say, there were questions about the VIE structure they didn’t address”.

The consequences of restricting VIEs in sectors outside of education would be so severe that some are confident Beijing would not eradicate them completely.

“The government will allow the VIE structure to survive, but one thing is clear: if a company wants to use the VIE structure to circumvent certain regulations then that is not going to work,” said Min Chen, head of China at $8bn emerging markets specialist Somerset Capital Management.

Rather than selling out of China altogether, some investors say they are focusing on trying to select stocks that are in line with the government’s strategic priorities. 

“Companies such as taxi-hailing groups or community group buying businesses, where their model is to use their competitive pricing advantage to squeeze out smaller players are likely to find themselves vulnerable to more regulation,” said Chen. “There is also the potential for winners in this environment, such as domestic leaders in the tech space and semiconductor producers . . . as well as companies that are exposed to mass consumption.” 

Alice Wang, a London-based fund manager at €2.7bn Quaero Capital, agreed that investors will need to switch to betting on sectors that are “important to China’s long-term economic future . . . areas like renewables and industrial automation companies that drive the ‘Made in China’ narrative.”

David Older, head of equities at €41bn asset manager Carmignac, echoed these sentiments and said he likes sectors such as semiconductors, software, renewable energy, healthcare and electric vehicles. He is overweight China and has been adding to his positions this week: “It’s a great buying signal when you see strategists saying that China is uninvestable.”

Trying to align yourself with the government’s strategic objectives “is the only way you can sleep at night”, said Horatius Capital’s Armstrong.

Chinese government intervention is about addressing its “demographic time bomb,” he said. “This is a Chinese problem and there will be a Chinese solution. You can come along and be a passenger if you want, but the ride is not going to be smooth.”

International asset managers rush to tap ‘huge’ China wealth opportunity

Some of the world’s biggest investors are pushing into China with wealth management joint ventures to create investment products for the country’s vast and growing pools of savers. A report from Boston Consulting Group and China Everbright Bank showed that China’s wider wealth market was worth Rmb121.6tn ($18.9tn) in 2020, up 10 per cent from a year earlier. 

While China’s wealth management sector is still dominated by banks, early overseas movers include Europe’s Amundi and Schroders, and BlackRock, JPMorgan Asset Management and Goldman Sachs Asset Management from the US, lured by the country’s liberalisation of its financial markets.

“There’s a fast-growing middle class in China that has huge [asset management] needs for savings and retirement,” said Valérie Baudson, chief executive of €1.8tn group Amundi, which recently launched a wealth management subsidiary with the Bank of China. This year the joint venture has launched over 50 funds to sell to the Chinese bank’s network of clients, and raised €3.4bn in assets. 

Executives downplayed the political risk of these initiatives, pointing to the importance of partnering with domestic Chinese institutions. “It’s not a risk that keeps me up at night. For us it’s about a long-term investment,” said Peter Harrison, chief executive of £700bn asset manager Schroders, which gained approval in February for a wealth management subsidiary with China’s Bank of Communications. Bringing Schroders’ long-term investment approach to China, “is very much for the benefit of long-term Chinese savers,” he added.

The value of Amundi has been updated since first publication.

Additional reporting by Eric Platt in New York



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Analysis

Can plant-based milk beat conventional dairy?

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Plant-based milk brands are churning up the global dairy business, with a surge in sales, investment, and new products coming to market. The plant derived dairy trade is now worth an estimated $17bn worldwide.

Growing consumer demand has boosted investment. According to data firm Dealroom, venture capital funding across the plant-based dairy and egg sector has skyrocketed, from $64m in 2015 to $1.6bn in 2020.

The world’s biggest food company, Nestle, recently launched its first international plant-based dairy brand, a cow’s milk substitute made from yellow peas. Wonder will come in a variety of flavours, competing with established brands like Oatly oat-based milk. Founded in Sweden in the 1990s, that company is now valued at around $15bn. Demand for alternatives to soya, which once dominated the dairy free market, continues to escalate.

In the west, sales for other plant-based milks, including oat, cashew, coconut, hemp, and other seeds overtook soya back in 2014. Since then, they’ve raced ahead to be worth almost three times as much as soya products, with a combined projected value of more than $5bn in sales by 2022.

Advocates argue that plant-based production emits less greenhouse gas than cattle, making it the way forward to help feed the world and curb global warming. But dairy groups are fighting back with their own sustainability campaigns. And cow’s milk is hard to beat when it comes to naturally occurring nutrients, like protein, vitamins and minerals.

The average 100 millilitre glass of cow’s milk contains three grammes of protein, compared to 2.2 grammes in pea milk and just one gramme in oat-based substitutes.

Dairy producers have also won a legal bid, preventing vegan competitors in the EU from calling their products milk and yoghurt. Despite their growing popularity, plant-based brands are a long way from displacing conventional milk products. Their current $17bn turnover is still a drop in the pail, compared with the traditional cattle-based dairy trade, which is worth an estimated $650bn worldwide.



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'It’s more than sport – every day we are fighting for our rights to be equal’

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French pro basketball player and podcaster Diandra Tchatchouang on her role beyond the court



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