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More and more, LBOs are becoming hot potatoes

August 22, 2012: 2:15 PM ET

Private equity firms may have trouble justifying fees in repeat deals.

FORTUNE --  Increasingly, private equity is looking like a roach motel. Deals check in, but they never check out.

Take Simmons, one of the industry's most notorious hot potatoes. Over the past two decades the mattress company has been handed via leveraged buyouts from one private equity fund to another. In the early 1990s, it was owned by a unit of Merrill Lynch. Since then it has passed through the hands of Fenway Partners and famed private equity shop Thomas H. Lee. Earlier this month, Simmons was on the move again, this time from Ares Management and the Ontario Teachers' Pension fund to Advent as part of a $3 billion deal for AOT Bedding, which owns Simmons and rival Serta, itself no stranger to private equity firms.

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The Simmons deal has plenty of company. Recently, it seems, the most active buyer of private equity's leveraged buyout deals have been other LBO funds. In the second quarter, 51% of all leveraged buyouts were bought with new debt by other private equity firms, according to Standard & Poor's Capital IQ.

So-called secondary buyouts have been around for a while, and have been rising as a portion of deals since the financial crisis. But the second quarter was the first time since Capital IQ began tracking the data a decade ago - and likely the first time in the history of private equity industry - that LBOs themselves have made up the majority of the buyers of other leveraged deals.

A leverage buyout usually entails a public company, or a division of a public company, being bought with debt by a private equity fund. After some time, private equity firms have traditionally sold those companies to other companies or back to the market in a public offering for a higher price than what they paid. But with corporate executives skittish about spending their cash and initial public offerings, especially in the wake of Facebook (FB), relatively rare, private equity firms are picking up deals that would normally go elsewhere.

That may make sense. Nonetheless, at a time when private equity is already under fire, the fact that increasingly the only buyers pe firms can find for their deals are other pe firms could be added fodder for those who claim that the private equity industry creates little value - other than for itself.

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"Does it say something about private equity," says Stefano Bonini, a finance professor at Bocconi University in Milan, Italy, who has followed secondary deals. "Probably yes in the sense that private equity funds have probably overgrown in the past and there is too much cash for too few really good deals."

In a recent study, Bonini looked at just over 2,900 private equity deals. While he found that private equity firms were able to improve performance and boost the value of companies they bought from the market or other companies, Bonini said that doesn't appear to be the case when the seller is another private equity firm. Once a private equity firm has bought and sold an investment, most private equity buyers struggle to add value the second time around. "Our findings show that follow-up deals create little, if any, differential value," says Bonini.

Others studies have showed that secondary deals make sense. Private equity veterans argue that firms have different expertise. So even after an initial buyout, a new private equity firm might make changes that the first private equity firm may not have thought of or tried.

At the very least, though, the growth of secondary buyouts could put pressure on fees. Christian Figge, a finance professor at Technische Universität München who has co-authored studies that found secondary deals add value, says private equity firms are paid, at least in part, for their ability to find attractive investments. If investors see that more and more of those investments come from private equity's own backyard, it will become harder and harder for managers to justify their fees.

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Stephen Gandel
Stephen Gandel

Stephen Gandel has covered Wall Street and investing for over 15 years. He joins Fortune from sister publication TIME, where he was a senior business writer and lead blogger for The Curious Capitalist. He has also held positions at Money and Crain's New York Business. Stephen is a four-time winner of the Henry R. Luce Award. His work has also been recognized by the National Association of Real Estate Editors, the New York State Society of CPA and the Association of Area Business Publications. He is a graduate of Washington University, and lives in Brooklyn with his wife and two children.

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