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Game of Hot Potato

25 June 2007 By Hugo Dixon

Why do leveraged buyout houses play hot potato? The industry’s habit of selling assets to each other – as with last week’s $16bn sale of Intelsat – can seem mysterious. Surely, after one private equity house has squeezed the lemon, there can’t be much juice left for the next guys? Or if there is, why don’t the first guys hang onto the company?

The answer could be skewed incentives. Remember that the working partners in private equity funds get a share of the profits on deals – typically 20% – but they do not share in the downside if there are losses. Such a remuneration structure can give them an artificial incentive to lock in profits by selling – even if they think there are further profits to be had by hanging on.

To see how, consider a fictional example where an LBO house – let’s call it Money-Go-Round LLP – invested $1bn in Hot Potato Inc some time ago. It now has a choice. Either it sells Hot Potato to another private equity firm, Secondary Specials LLC, for $2bn. Or it continues with the investment for a bit longer. What should it do?

Well, first look at what happens if Money-Go-Round sells out. It immediately books a $1bn profit. Its share of the profit, the carry, comes to $200m.

Now examine what happens if Money-Go-Round stays the course. Say it thinks there’s a 50% chance that Hot Potato’s value will double again to $4bn in a year’s time. But there’s also a 50% chance that its value will fall back to $1bn. Half the time, it will book a $3bn profit – on which its carry will be $600m. And half the time, there’ll be no profit at all. On a probability-weighted basis, its carry is therefore $300m.

It might seem that there’s more money to be made by hanging onto Hot Potato. But that ignores the fact that, if Money-Go-Round sells out, it can hand the cash back to investors, raise a new fund and invest in a new venture.

Imagine Money-Go-Round now does precisely that – investing its new $2bn fund in Hot Potato 2.

Hot Potato 2 is being sold by, you guessed it, Secondary Specials. This new business has exactly the same investment characteristics as the original Hot Potato (from now on, Hot Potato 1, to avoid confusion). In other words, there’s a 50% chance that its value will double to $4bn – but also a 50% chance that it will halve to $1bn.

In the upside scenario, Money-Go-Round books a $2bn profit on Hot Potato 2 – on which its share of the carry is $400m. Obviously, there’s no carry in the downside scenario. So on a probability-weighted basis, it can expect $200m of carry. Now add that to the $200m of carry it has already cashed in by selling out of Hot Potato 1, and MGR can expect $400m from the double investment – rather than the $300m it could have expected to make if it had just stuck with Hot Potato 1.

How, one might wonder, has this extra $100m been generated? The answer is that, by locking in its profits on Hot Potato 1, Money-Go-Round no longer gets hit in the downside scenario. If the worst comes to the worst, its partners still walk home with $200m. In effect, by swapping identical assets, they were able to crystallise gains for themselves in the middle of the game even though, by the end of the game, the underlying improvement has melted away. They got away with the money while the going was good.

Something, of course, doesn’t come from nothing. The gain to the working partners is at the expense of the outside investors. This is clearest to see if one imagines that they have invested in both Money-Go-Round and Secondary Specials. In the scenario where Hot Potato falls back to its original $1bn value, the outside investors only end up with $800m. It might be better for them if the money-go-round stops.


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