If it feels like there have been more sponsor-to-sponsor transactions this year, you’d be right. While these deals have always been a viable exit strategy, they are rising to new levels of popularity.
“Preliminary data from the first quarter of 2014 show about 45% of PE exits coming from secondary buyouts,” writes Devin Matthews in a recent article. The frequency is a notable increase from the 41% from 2011 – 2013 and the estimated 36% pre-2008.
The Slowdown in Other Exit Channels
The recent spike in secondary buyouts is likely a reaction to dissatisfaction with the public markets. Although IPOs were a preferred exit strategy just a few months ago, a dismal week of flotations in early April caused many PE firms to reconsider the strategy. In that week, 8 of the 10 IPOs debuted below their expected range — the worst performance since 2004.
Fearing that the public markets could not offer desired returns, sellers turned to their other primary options: strategics or secondary buyouts. While PE firms often prefer to sell to strategics, the current environment — high dry powder, low deal flow, low interest rates, and pressure to exit portfolio companies — has made sponsor-to-sponsor transactions a very appealing alternative.
Although secondary deals may be on the rise, not everyone is happy about it. “The surge in secondary deals is generally a good thing for GPs, but not necessarily so for LPs,” writes Luisa Beltran in her article.
For LPs, a sponsor-to-sponsor transaction may offer no benefit. Jeff Golman explained, “Many of the [LPs] are in both buyer’s and seller’s funds, therefore, they don’t get liquidity and end up investing in the same company at a higher price.”
LPs find this situation particularly troubling when there is doubt that the second sponsor will be able to grow the business further. Golman continued, “Often, the private equity seller has wrung whatever savings and efficiencies out of the company that they could under their ownership, leaving less juice for the buyer.” If the second sponsor is unable to grow the business sufficiently, the only takeaway for the LP is additional fees and prolonged capital illiquidity.
Good for Lower Middle Market
LPs, however, tend to be more open to these flips when the deal involves two differently-sized sponsors — like a lower middle market firm selling to a larger firm. As one LP commented, “The first sponsor professionalizes the business and grows it to a ‘decent size’ before selling.” Not only are larger firms hungry for deals, ones that have already had institutional presence are likely to have fewer skeletons in the closet or hair on the deal.
The current popularity of these ‘upward sells’ is favorable for lower middle market firms. As smaller firms partner with exiting business owners, they can help professionalize the business without extracting all of its growth potential. Since larger firms are clamoring for the deals, the business could be transitioned at a healthy valuation.
Tim Shanley, of Huron-backed Victoria Fine Foods, confirmed the benefits of these small-to-large secondary deals during one of our recent events. At the discussion, Shanley explained that the sponsor-to-sponsor transaction can be particularly valuable for the operating company if the company is sold to a more experienced sponsor. In addition to their experience, larger firms are able to write larger checks to further accelerate the growth of the company.
He cited the the franchise industry as a prime example; newer private equity firms will purchase regional stores to bring them to the national level. Upon exit, once that next level is reached, the more experienced players have developed an interest and can take the company even further — aiming for a strategic exit at the end of their 5-7 year window.