(Bloomberg) -- Private equity firms’ strategy of shuffling assets to buy more time for investments to pan out is starting to show signs of weakness.
More than 100 so-called continuation funds were raised between 2019 and 2021 to move portfolio companies from one private equity vehicle to new ones backed by fresh capital. Some are now running into trouble amid a sluggish dealmaking environment and declining asset values.
Enviva, a supplier of wood pellets that Riverstone Holdings rolled into a 2020 continuation vehicle, emerged from bankruptcy in December with a restructuring agreement that cut $1 billion of debt and gave control of the company to a new shareholder.
Wheel Pros, a tire manufacturer operating as Hoonigan, also exited Chapter 11 last month with a restructuring agreement that handed ownership to a group of lenders. Clearlake Capital Group moved the company into a continuation vehicle in 2021.
Cracks are emerging elsewhere.
Revelstoke Capital Partners shunted Upstream Rehabilitation into a $660 million continuation vehicle in 2019 to fund its strategy of consolidating the physical therapy market. But Revelstoke marked down Upstream’s valuation in recent quarters as its earnings deteriorated, according to private financial documents seen by Bloomberg. Upstream’s public debt trades at levels suggesting financial stress, with a secured loan due in 2026 trading at roughly 83 cents on the dollar, according to data compiled by Bloomberg.
Private equity firms are increasingly turning to continuation funds to help them hang on to prized assets for longer if they believe there’s more upside, need more time for a turnaround or want to wait for a better climate to sell. The industry has unloaded fewer portfolio companies since the Federal Reserve started raising interest rates in 2022.
“The exit markets continue to be constrained,” Conrad Axelrod, a partner at law firm King & Spalding, said in an interview. “We’ve had extended holding periods and secondary sales on the rise for at least the last five years.”
A continuation fund typically has half the lifespan of a traditional buyout fund — about five years — meaning that many of those raised in 2019 and 2020 are reaching maturity. Investors in those funds will be agitating for sales or other ways to recoup their money, although not all may be able to exit.
Some of the biggest limited partners, public pension funds, have brought in extra help to get a better handle on their increasingly complex investments, including continuation vehicles, according to people familiar with the matter. California State Teachers’ Retirement System and the Los Angeles County Employees Retirement Association are among those that hired consultants and other specialists to assist them with the often Byzantine arrangements PE firms use to prolong the lives of assets.
Lacera, which managed about $82 billion in pensions as of November, recently set aside money for a newly created role that will oversee operational due diligence across its private markets exposures, according to a person familiar with the matter.
“The days of writing checks and waiting for an exit and your money back is over,” said Jean-Philippe Boige, managing partner at Reach Capital, a private-market fundraising firm. “LPs need to be as informed as possible as there’s more financial engineering and levers being pulled by PE now.”
The pension funds declined to comment.
In the case of Upstream, adjusted quarterly earnings declined steadily over the 12 months through June, according to the financial documents seen by Bloomberg. During that span, Revelstoke lowered its estimate of Upstream’s return on investment to 1.75 times from 2.47 times.
The debt market takes a more dire view of Upstream, which describes itself as the “largest pure-play outpatient physical therapy provider in the US.” The company’s secured loan due in 2026 yields about 19%, data compiled by Bloomberg show, implying significant risk of non-repayment and financial strain.
Debt held by other PE-owned companies that have been rolled into continuation vehicles in recent years shows similar signs of strain.
United Site Services, a portable-toilet provider backed by Platinum Equity, has a senior secured term loan due in 2028 that’s trading for about 63 cents on the dollar to yield roughly 23%. The PE firm rolled the asset into a continuation vehicle in a 2021 transaction that valued United Site at $4 billion.
The company’s third-quarter adjusted earnings tumbled 26% to $52 million from a year earlier, according to a person with knowledge of the matter. Those results follow a September distressed debt exchange that United Site pursued to buy more time for repayment.
Audax Private Equity raised $1.7 billion in 2021 to extend ownership of several portfolio companies, including Innovative Chemical Products Group, whose second-lien guaranteed loan due in 2028 yields about 27%.
“ICP Group’s performance is not reflective of the broader continuation fund portfolio, which has increased nearly 40% in value since its inception,” an Audax spokesperson said in a statement. “While ICP has faced industry headwinds in recent years, Audax has enacted multiple operational initiatives, which have driven margin recovery and positioned the company for long-term growth.”
Owning portfolio companies with lower valuations or debt trading at distressed levels doesn’t necessarily mean that private equity firms can’t eventually turn things around.
Fed rate cuts and a pickup in deal activity in the second half of last year could help the industry find its way out of the dealmaking drought. And pockets of distress aren’t likely to slow a market that has grown so dramatically in recent years.
While there have been “blips” in the secondaries market, the asset class continues to perform well, said Isabel Dische, partner and chair of the alternative asset opportunities group at Ropes & Gray.
“The deal volume will continue to be up,” she said, “and is probably going to continue to grow in the years ahead.”
