Secondary buyouts – PE firms selling portfolio companies to other PE firms, as opposed to corporate buyers or public markets via an IPO – are also known as sponsor-to-sponsor transactions in private equity. According to Preqin, secondary buyouts now account for 30% of global deal flow, double the percentage in 2007. So far in 2011, 291 secondary buyouts worth an aggregate value of $60.4bn have been completed, surpassing 2010’s figure of 251 worth a combined $52.6bn.
There are reasons why secondary buyouts appeal to PE firms, yet draw the ire of some Limited Partners. The latter group is less than thrilled in certain cases in which they have invested in both private equity firms involved in the hypothetical transaction. If this happens to be case, the transaction is a wash (a net negative with fees) – although overall the LP may have profited on the portfolio company since its purchase years prior, and may stand to profit from further improvements by the buying GP, he would essentially be selling the company to himself in the deal, not turning over the asset, and keeping its same risk. Yet if an LP is comfortable with the company in question and confident in his GPs, he stands to benefit from the upsides secondary buyouts offer in building businesses; and concurrently there are clear factors why GPs like secondary buyouts in the first place.
Climbing the value chain
Private equity firms have different kinds of talent and areas of expertise, different ways they add value to a company. Some GPs have developed their expertise around investing in companies of a certain size, and are limited how much they can grow it. For example, a firm like The Riverside Company can buy a sub $5M EBITDA company and bring it to $20M implementing several rounds of operational improvements, while a secondary PE firm can make subsequent improvements and scale the company even larger until an eventual exit.
“Bringing businesses to next level is one of the things we look at with secondaries. Many PE-backed companies are lightly touched under prior ownership, leaving a lot of runway left,” said Thomas Franco of Clayton, Dubilier & Rice at the 2011 Yale School of Management Private Equity conference.
Robert Landis, Partner at The Riverside Company, went into further detail and expounded on Tom’s preamble, “The number of companies we have bought that are on Byzantine accounting systems is astonishing. Quikbooks is great for really small companies…[but] there is a progression. We can get a company to a certain point, and then Tom can bring it even further because he has an expertise that we don’t.”
Expanding geographic reach
Some private equity firms like Zephyr and KKR have wide international scope in which to expand sales and thus value, especially in certain emerging markets. Norm Alpert from Vestar Capital Partners touched on this point, “We can take companies international, or from smaller markets to bigger ones. That is one of the benefits private equity offers.”
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Raed Elkhatib of Credit Suisse Private Fund Group offered a macro opinion that, “Places like Colombia, Indonesia, and Southeast Asia – the next frontier – aren’t really ‘next’ anymore, they are now.” However, it is easier said than done to tap these markets – “You need to have local JV partners on the ground to succeed,” Raed emphasized – and certain firms are deeply entrenched with local connections that other firms do not have. Therefore, a secondary buyout with the intention to expand into hard-to-access territories opens opportunities for growth not otherwise available to the company or the LPs.
Recouping immediate payoff
One of the clear benefits to a PE firm exiting via a secondary buyout is that the sponsors get paid a lump sum as opposed to staggered, uncertain compensation that comes with IPOs and their lockup periods.
Yet for those LPs invested in both sides of the deal, “It is fairly frustrating – nothing has really changed in the portfolio and you have to pay more fees,” said Lee Gardella, managing director at Swiss fund-of-funds manager Adveq, in a 2010 interview with Private Equity News.
The secondary buyout phenomenon is likely not going anywhere soon. Managing Director at JLL Partners, Ramsey Frank gave reason for this thesis and summed up the discussion:
“The secondary buyout trend will probably continue because the IPO market is not a great exit strategy for mid-market companies that are not hyper-growth right now, and they may be stuck for a long period of time and hard to fully exit, whereas through a sale to another PE firm you recoup [your investment] all at once. Companies go through a life cycle. Sometimes we can only take companies so far with our capital base and need to hand it off to other, bigger firms like TPG that have the capital to take it to another level. We’ll bring it to $120M EBITDA, then they’ll bring it to $300M EBITDA. Small firm sells to big firm, big firm sells to mega firm, and mega firm hopefully sells to multinational.”
Private equiteers are masters of creating efficiencies and building profitable companies. Yet there is a certain ecosystem in the private equity industry, replete with specialists in different crafts of value creation. Sometimes secondary buyouts are necessary to realizing a company’s potential, as they effectively pass the company from one specialist to another, ensuring a holistic business improvement over the course of its life as opposed to getting better once in just one facet. Although sometimes Limited Partners negatively refer to secondary buyouts as “passing the parcel,” the process is helpful and sometimes necessary for building a company to its full potential and scale.