Pass-the-parcel

When Guy Hands, founder of buyout house Terra Firma, criticises the boom-time private equity practice of “pass-the-parcel” secondary buyouts, it’s easy to see his point.

In the recent credit-driven private equity glory years, a significant wall of capital was chasing a limited number of deals – particularly in the more developed private equity markets – and so financial sponsors were more inclined to buy assets from each other.

“We saw an increasing number of pass-the-parcel transactions between general partners, where limited partners essentially retained the same asset while paying fees and carry each time it changed hands,” Hands reportedly said at a conference in Berlin yesterday.

The practice of “quick-flipping” assets tears through the fabric of the only really defensible aspect of the asset class: that private equity creates value in its portfolio companies through operational changes. If a private equity firm has extracted – or should we say maximised – the value of an asset, you could argue that it is impossible for the next private equity firm to do the same without relying solely on financial engineering.

But even Terra Firma was not impervious to the benefits to be reaped from secondary buyouts.

After narrowly missing out on the landmark take-private of Boots Alliance, Terra Firma acquired Pegasus Aviation Finance, an airplane leasing business, for $5.2 billion from Oaktree Capital Management in 2007.

And then there was Autobahn Tank and Rast, the German motorway services operator bought by Terra Firma for $1.3 billion from Apax Partners and Allianz Capital Partners in 2004.

When Terra Firma bought Odeon Cinemas that same year for £400 million, it was from West LB Private Equity, which itself had bought the cinema chain just 18 months earlier from buyout house Cinven.

In fairness to Terra Firma, these are just isolated examples. Looking at the bigger picture, of the 41 announced deals involving the firm since the beginning of 2003, only six were transacted with other private equity investors, according data provider Dealogic. So Terra Firma’s record does, on the whole, stand up to the scrutiny invited by Hands’ recent comments.

But did the “pass-the-parcel” deals described by Hands really contribute significantly to the private equity bubble, or were they merely a symptom of the wider credit bonanza?

In an environment in which bankers’ remuneration was based on how quickly they could get money out of the door, rather than the quality of their loan book, it is hardly surprising that firms were exploring all sources of deal flow.  

David Rubenstein, co-founder of the Carlyle Group, came to the candid conclusion at a recent Harvard Business School conference that errors had been made by both the banking sector and the buyout industry given the heady environment in which they were operating.

“I analogize it to sex,” Rubenstein said. “You realize there were certain things you shouldn't do, but the urge is there and you can't resist.”

While some will argue the industry can't afford to admit it used tactics it now deems questionable, comments like Rubenstein’s and Hands' are an important part of the asset class’ evolution. As it reinvents itself for this very different market cycle, the private equity industry needs to be self-critical and own up to its excesses, lest it repeat mistakes.