One reason for the company’s success, according to an attendee and documents shared at the meeting: Clearlake sold the companies it owned from one set of investment funds to another set of funds it also managed, called “continuation vehicles.”Continuation funds are intended as a temporary solution to a serious problem affecting companies like Clearlake.
Private equity firms are struggling to deliver on their core business model, which is taking on debt, buying companies and selling them for a profit. Several years of high interest rates have made it too expensive for many potential buyers to buy indebted companies, and private equity firms are facing a record backlog of more than 31,000 unsold companies. Towards the end of this year, transaction activity increased, but not enough to make a significant dent in the order book.
Continuation vehicles provide a short-term solution by allowing companies to sell the businesses to themselves, book a paper profit and wait for interest rates to improve.
Private equity firms have increasingly turned to this strategy. According to investment bank Evercore, the dollar value of follow-on vehicles in the industry is expected to total $100 billion or more by the end of 2025, up from about $35 billion in 2019. Private equity is one of the largest parts of the global economy, with more than $7 trillion in investor money, and some of those investors are increasingly concerned that strategies like follow-on vehicles are delaying a painful reckoning. Private equity firms say they are selling only their best-performing companies to continuation vehicles, which would yield big profits if the companies can eventually be sold to outside buyers.
The risk, investors say, is that the isolated nature of these sales — where the private equity firm is both the buyer and the seller — leads to questionable valuations and unrealistic projections, leaving investors vulnerable to painful surprises.
At the 2022 meeting of Clearlake’s pension trustees and other clients at the Monarch Hotel, the company boasted about the success of Wheel Pros, a car accessories retailer it had sold to one of its follow-on funds.
The company sells eye-catching hubcaps and other wheel accessories, which were popular during the pandemic, when consumers were flush with stimulus money and had time for DIY projects.
Two years after that meeting, in September 2024, Wheel Pros declared bankruptcy as sales slowed after the pandemic. The company could not keep up with rising debt levels. Every investor, including public employee pension funds from New York, Connecticut and Nevada, was wiped out. (Connecticut and Nevada had previously sold out part of their stakes in Wheel Pros.)
Clearlake Capital declined to make its executives available for an interview. In a 2023 podcast interview, Jose E. Feliciano, a founder of the company, said it used continuation vehicles for “companies that were A-plus assets that we wouldn’t mind owning for a long time, maybe forever.” He added that this also applies to companies that need more time and investment to realize their full potential.
Platinum Equity, another company, has struggled with its investment in United Site Services, a company that makes portable toilets. In 2021, Platinum Equity executives described the sale of United Site Services to a follow-on fund it created as a “win-win situation.” Now United Site Services is in the process of transferring the company to its lenders, and the investors are expected to lose all their money. “Continuation vehicles indicate rot in private equity,” said Marcus Frampton, chief investment officer of the Alaska Permanent Fund Corporation, which manages $83 billion in state money derived from oil revenues and distributed annually to Alaska residents.
The increased use of these funds, he said, is one reason why the Alaska fund has scaled back investments with private equity firms. Frampton said the companies were reviewing their goal of creating value through buying and selling businesses. In 2021, the Alaska fund owned 22% of its dollars in private equity firms. Now it owns about 17%.
Scott Ramsower, who oversees private equity investments at the Teacher Retirement System of Texas, a pension fund that manages about $229 billion, said there were inherent conflicts in follow-on funds because typically there is a private equity firm involved on both sides of the deal.
“We would be happier if a private equity firm never did this,” Ramsower said of follow-on funds.
The private equity industry says there are no conflicts because the deals are independently vetted. First, a private equity firm’s largest investors must agree to the sale of a portfolio company to a continuation vehicle. Then, existing and new investors have the opportunity to take a closer look at the company’s financial situation and decide whether to make a deal at a certain price tag. If the investors don’t see the benefit of future returns for a specific company when it is eventually sold to an outside buyer, the deal won’t go through.
But some investors say this vetting process is not always transparent.
This month, Abu Dhabi’s sovereign wealth fund filed a lawsuit in the Delaware Court of Chancery, alleging that Energy & Minerals Group, a private equity firm, sought to “gain a huge benefit for themselves” at the expense of their investors by selling a company to a continuation vehicle.
According to the lawsuit, the company tried to force the sovereign wealth funds and other investors to vote on the sale on short notice, provided different data to different investors and did not allow the investors to consult with each other on the deal.
Energy & Minerals Group did not respond to requests for comment.
Nigel Dawn, global head of Private Capital Advisory at Evercore, said the failure rate at continuation funds has so far been below the rates of traditional buyout funds, which range between 5% and 10%.
#Investors #warn #rot #private #equity #funds #circular #deals