Private equity turns to more financial engineering as returns sink

The gyrations of public markets so far this year have been dizzying, but signals from private markets are equally nausea inducing. Industry experts and practitioners are expressing pessimism and some say alternative assets are in irreversible decline. Faced with mediocre returns and overripe assets, buyout firms are conjuring exit strategies to return capital to investors.

The White House Executive Order in August in response to industry lobbying to open the 401(k) world to higher risk alternative assets ignores private equity’s exorbitant fees and underperformance relative to the stock market over 1-, 3-, 5- and 10-year periods, per State Street data.

Although the private funds industry is optimistic about expanding its customer base to 401(k)s, it’s not an immediate fix to significant challenges including a $1 trillion backlog of unsold assets, economic turmoil, bankruptcies, and sluggish fundraising.

“Alts bring extraordinary costs but ordinary returns,” according to influential industry consultant Richard Ennis, co-founder of EnnisKnupp, whose new research predicts the demise of alternatives as an asset class. In an interview with Bloomberg, Ennis described the complexity and high fees of private equity and venture capital as “costly and wasteful.”

The failure of alternatives like private equity to deliver superior risk-adjusted returns after fees in the 15+ years since the Great Financial Crisis will spell the unraveling of the industry, Ennis forecasted, saying, “Alts cost too much to endure as a permanent part of institutional investment portfolios.” 

In March Bloomberg reported from the Qatar Economic Forum, quoting the head of Kuwait’s $1 trillion sovereign wealth fund, “Private equity is very troubled, I believe, especially in the large buyouts, venture capital and the rise of continuation vehicles — that’s a very worrying sign,” Sheikh Saoud Salem Al-Sabah said, “Their time is coming up.”

Egyptian billionaire investor Nassef Sawiris told the Financial Times, “Private equity has seen its best days.”

KKR sees things differently, with CEO Scott Nuttall earning this headline in Australia’s Financial Review: “KKR CEO: Don’t believe ‘private equity is dead’ narrative.”

But the Wall Street Journal wrote in April that “Private Equity World (is) Engulfed by Perfect Storm” as firms struggle with a multi-year logjam of portfolio companies that has ballooned to 29,000 and no relief in sight.

At the $500 billion asset manager Neuberger Berman, the head of European private equity Joana Rocha Scaff told Bloomberg, “You typically would see 25 percent of your portfolio being harvested, and realizing  cash being sent to you annually, that is very precious money.” But over the past three years, she said the exit rate is more like 12 to 13 percent, “This is a big problem.”

From frying pan to fire?

With private equity’s investors parched for liquidity, strategies like secondary sales and continuation funds have surged to quench their thirst. According to McKinsey, in 2024 total secondaries deal volume grew by 45 percent year over year to $162 billion, breaking previous records. General partner-led secondaries similarly increased by 44 percent to $75 billion.

Secondary sales refer to the sale of existing stakes in a commingled fund, usually at a discount, before the fund has been liquidated by the general partner (GP). Continuation funds usually refer to when a GP plucks an asset (or sometimes multiple assets) out of a commingled fund and sells it to itself as a new vehicle inviting new investors to participate.

While such strategies may provide some short term relief from the liquidity drought, they also can be complex and it’s not clear that the growth of GP-led secondary sales and continuation funds will yield favorable outcomes. Limited partners would prefer traditional exits, and fewer than 1 in 5 would opt for a continuation fund exit, according to a Bain-ILPA poll.

Bloomberg examined how continuation funds from the 2019-2020 are faring as they reach the typical five-year maturity mark, and found that “some are now running into trouble amid a sluggish dealmaking environment and declining asset values.” 

The complexity of continuation funds, usually led by the general partners (GPs), have been a source of frustration for limited partners (LPs), according to the Institutional Limited Partners Association (ILPA) which noted, “These transactions are conflicted by nature, with the GP sitting on both sides of the transaction.”

BNP Paribas said continuation funds bring complexity and risk, including conflicts of interest, misalignment and “artificial” liquidity that “doesn’t necessarily reflect a true exit from the asset.”

“Continuation funds is the biggest scam ever because you say ‘I cannot sell the business, I’m going to lever it again’,” Sawiris said in his interview with the Financial Times. 

Continuation fund investors were wiped out in the bankruptcy of Clearlake’s Wheel Pros last fall, crushed under its debt service, a collapse that the Financial Times said, “underscores the potential pitfalls when a deal goes badly with a private equity shop that is both a buyer and seller of an asset.”  

To address investor concerns about continuation funds, ILPA developed guidance with “general parameters for well-run continuation fund transactions that will foster more informed decision-making by LPs and more aligned outcomes overall.”

The recommendations include disclosures and mitigation of conflicts of interest, as well as that the asset being sold into a continuation fund is valued appropriately: “a competitive process should be run to ensure a fair price was obtained; the process should include third party price validation.”

Private equity firm Blue Owl’s co-chief executive Marc Lipschultz cautioned that secondaries transactions with a 20% discount were “not picking up dollars on the ground for 80 cents. Things that are worth $1 don’t sell for 80 cents. That’s not how a functioning marketplace works.” A discounted price in a secondary sale suggests that “the asset values for stakes on countless other investors’ balance sheets may be inflated,” the Wall Street Journal reported. 

But there are also examples on the flip side, of valuation markups after a secondary sale that defy logic, and underscore creative accounting and the asymmetry between buyers and sellers that are fostered by the opacity of private market deals. The Wall Street Journal tracked on-paper valuation markups of over 1000% within days of a deal, which conveniently boost the new owners’ profits and performance metrics instantly. Such deals also generate new fees for the GPs.   

Private equity will likely continue to employ a range of financial engineering tricks to juice their income in the face of ongoing headwinds. These include secondary sales and continuation funds to afford current investors some relief from illiquidity as dealmaking has slowed further in 2025 and global market turbulence, trade wars, high interest rates, and a reluctant IPO market persist. The executive order to open 401(k) retirement plans to private markets invites further risk, with critics worried private equity will turn them into a dumping ground.