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As we’ve watched PE sponsors increasingly reshuffle their deck of portfolio companies through secondary buyouts, some prominent commenters have expressed concern that private equity investments may be taking on many of the characteristics of a Ponzi Scheme. This excerpt from a Washington Post article published earlier this year indicates that this has become a concern for, among others, the CIO of Europe’s largest asset manager:

Vincent Mortier, chief investment officer of Amundi SA, Europe’s largest asset manager, questioned how private equity firms can keep their performance aloft even as the market for initial public offerings slumps:

The vast majority of deals are currently done between private equity players… One private equity player will sell to another one who is happy to pay a high price because they have attached a lot of investors. When you know you are able to exit your stake to another private equity house for multiple of, let’s say, 20, 25 or 30 times earnings, of course you won’t mark down your book… That’s why I’m talking about a Ponzi because it’s a circular thing.

Mortier’s concerns were recently echoed by Mikkel Svenstrup, the CIO of Denmark’s largest pension fund, but a recent PitchBook article says that these concerns are overblown:

Put simply, a Ponzi scheme is a fraud where early investors are paid with funds obtained from later investors. This could mean investing in a company or technology that has no intrinsic value on the promise of substantial returns, and ending up with nothing. While investing in PE always carries the risk of losses, any comparison to the above is flawed.

Mortier and Svenstrup’s fears over a rush of secondary buyouts seem to me a tad overblown. Sure, this year has seen some particularly large deals, including Bain Capital and Hellman & Friedman’s $17 billion acquisition of Athenahealth from Veritas Capital and Evergreen Coast Capital. But PitchBook data shows that secondary buyouts accounted for less than 31% of exits this year in terms of volume; sales to corporations are still the preferred method.

These figures are in line with previous years, so concerns of a sudden increase in secondary buyouts don’t appear to be supported.

Furthermore, PE’s main strategy for buying companies, whether it be from each other or another party, remains buy-and-build, i.e. firms acquiring and adding smaller companies to an existing platform. Unlike a Ponzi scheme, where the investment remains static and therefore produces no returns, PE investors are expanding their portfolio companies’ operations to generate value and increase returns.

That being said, the article acknowledges that these critics have a point when it comes to portfolio company valuations, which lack transparency and can enable PE sponsors to show a high valuation —at least to outsiders—even in the midst of market turmoil. The SEC thinks they have a point too, and its proposed overhaul of the private fund adviser rules is intended in part to promote greater transparency when it comes to valuations and investor returns.

– John Jenkins