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Secondary sense

Secondary buy-outs have become an increasingly popular exit route over recent years and there's every indication that they will become still more so in the future. Should investors be worried?

If there's one thing that private equity houses are pretty much agreed on right now, it's that exit opportunities are about as rare as a snowflake in summer. After the hype and mania of the past couple of years, initial public offerings are no longer an option for most investments. And trade sales - the most common exit route - have all but disappeared as companies either cut back to cope with more difficult times or find themselves unable to raise further funding for acquisitions.

‘The climate for exits is the worst I've seen in ten years. It's certainly the worst it's been since the last recession,' says Ross Marshall of Dunedin Capital Partners. No exit means no carried interest for general partners. And, importantly, it also means no return to investors. Hanekke Smits of fund of funds Adams Street Partners is seeing this particularly in the mega-fund arena. ‘Our concern is really about the larger end of the market,' she says. We've seen a lot of deals done, but very few exits.'

It's hardly surprising then that venture capitalists are talking more and more about secondary buy-outs - selling their stake in a company to another private equity firm. And they're doing more than talking about it. In the year from September 2000 to now, secondary buy-outs accounted for 33 per cent of all private equity exits in the UK, according to figures compiled by Zephus Corporate Finance Knowledge. That's up from 20 per cent the previous year. Some of the more recent ones include Cinven selling its investment in General Healthcare to BC Partners, Duke Street selling Leisure Link to Henderson Private Capital, Botts & Company, Apax partners, Electra and Candover selling Asquith Court to West Private Equity and 3i selling its stake in Goodridge to Close Brothers Growth Capital. And the predictions are that we'll see ever more in the next few years.

UK private equity exits

Source: www.zephus.com

What about investors?
But where does this leave institutions - on both the seller's and the buyer's sides? Some might question whether this is the best use of their invested capital. After all, why would a private equity firm want to buy from another? Isn't a firm selling because it has invested in a dog? Or, if it's not a dog, why on earth does it want to sell? Have the fund managers been working hard enough to ensure that they achieve the best price for that all-important exit? Perfectly legitimate questions.

One of the main concerns raised is that an investor in a fund that is selling its stake may well also be an investor in a fund that is buying the stake. This may happen with increasing frequency as investors seek to diversify their exposure to private equity by investing in a wide spread of managers. The perception is that the investor will lose out on one side of the transaction, whatever happens. ‘The universe of fund investors is relatively small,' says Slade. ‘So it's not unlikely that the same investor will have invested in both parties in a secondary buy-out. Where does that leave them?' Even if you don't lose out on one side of the deal and it all balances out, you could argue that, in that particular portfolio investment, the institution will have gained little from the transaction, while the lawyers and other advisers will have gained some lucrative work. Again, in some cases, this could be quite true, especially if the buyer has made a poor judgment.

However, as private equity firms - and many seasoned investors - will tell you, it's more complicated than that. To understand why secondary buy-outs might not be such a bad thing for investors, you need to look more closely at why they are becoming more popular.

The context
Secondary buy-outs are nothing new. They've been a feature of the industry for many years. To begin with, they didn't have a great reputation. ‘Ten years ago, secondary buy-outs were taken as a sign of failure,' says Dominic Slade, a partner at Alchemy. Jonny Maxwell, chief executive of fund of funds player Standard Life, agrees: ‘The first one was done about 14 years ago. Back then, it was considered commercial madness to buy from a private equity house. And sometimes that was true.' Sellers were pretty nervous, too. ‘When they originally started, there were people who were worried about the embarrassment clause,' says Maxwell. ‘This was an arrangement the firm selling would negotiate with the firm that was buying that, if that firm then sold for much more within a certain time frame, then it would receive some of the upside. It was a defensive move so that the seller didn't look stupid.'

Fast forward a few years, and things have changed a lot, both in the private equity industry and in other markets.

Difficult times
The current downturn aside, exits have actually been hard to achieve since the early 1990s. ‘Fifty per cent of funds raised since 1992 have yet to sell all their initial investments,' says Slade. This is partly to do with the stock markets. ‘Currently, stock markets don't want or value small, low-growth companies, which is what many of these assets are. The IPO floats that were there as an exit route in the early 1990s just aren't available today. Whether they will ever come back is a moot point. I don't believe that they will.' This trend is evidenced by the steady stream of small publicly quoted companies opting to go private over the last five or six years. There is little point exiting an investment by floating a company if the market won't give you the best price. ‘If the quoted markets aren't interested in companies below a certain level, then private equity houses will own them over much longer periods of time,' says Ivan Heywood of Legal & General Ventures.

While the public markets have been turning away from smaller companies, the private equity industry has been steadily developing and maturing. The last ten years has seen the industry become increasingly segmented according to sector or stage specialisation. Where once private equity firms would invest in start-ups and buy-outs in anything from technology to retail, they now tend to focus on particular areas, whether they be early-stage biotechnology companies or MBOs in the leisure sector. They have also developed new investment strategies, not least of which is buy and build, whereby funds buy up small companies in the same or similar industries and merge them to create a more efficient - and more valuable - business.

In this environment, secondary buy-outs start to make more sense. Take one of Dunedin's deals. It invested in Lett's Diary, the UK office stationery company, and then acquired Filofax. Together, the two companies are worth much more than separately and are likely to appeal to a larger private equity firm that can then take the merged company to its next stage of development. ‘If you have different funds with different strategies, it's natural that firms will want to buy and sell to each other,' says Marshall. ‘Even good companies need to be sold. The suspicion that because you're selling that it must be a bad business is misplaced. These days, you can't just offload poor investments. Who would buy them?'

Strategic moves
In cases such as this, secondary buy-outs are far from being the last resort of the desperate, but are an investment strategy in their own right. ‘With some of our deals, we know from the very beginning that they are secondary buy-outs. When we buy them, we know that we'll sell them on to another private equity firm and quite often, we'll even know pretty much which one,' says Slade.

It's also worth bearing in mind that the nature of private equity investing actually creates the need for secondary buy-outs. Funds have a limited lifespan, usually set at ten years. As the market has matured, more funds have reached that critical ten-year period. There will have been many that have reached it with exits still to make. This doesn't necessarily mean that the fund's managers have misjudged an investment, or that the company is necessarily a bad one.

‘There are all sorts of dynamics within portfolio companies. People die, people move on, any number of things can happen after a fund has invested,' says Maxwell. ‘Say your fund winds up in 2001. You invested in a management team in 1995 and it was on target for the original exit strategy right up to 2000. Then, in 2000, something happens and the company isn't in the best shape to be sold that year. The company continues until 2001, but you and the management agree that it won't be ready for sale until 2003. What do you do? You don't want to take it to a trade buyer and you want to keep the management on side. So you sell it off to another private equity house.' The new owners will be able to take the business forward to the next stage and the sellers are able to exit the investment and return money to investors.

It's a far better solution than the alternative - passing on a stake in the business to investors. ‘What investors definitely don't want is for the fund to be wound up with distributions in specie where all the shareholder rights that go with the fund evaporate,' says Maxwell. ‘The fund holds the shareholder agreements, not individual investors. As an investor, you don't want a whole load of paper anyway, you want it even less if you have no rights.'

Time is money
Of course, private equity firms don't sell an investment in a secondary buy-out simply out of consideration for investors' interests. The decision is partly driven by firms' thirst for good internal rates of return, which will affect their ability to raise future funds. As IRRs are calculated by returns over time, it's in a fund's interest to exit investments as soon as they can achieve a good return. ‘The time effect of IRRs can weigh quite heavily,' says Maxwell. ‘If you want to draw a line under an investment and get on to raising the next fund with a firm track record, you have to look at exiting some of your investments. If you have some in your portfolio that are going to take longer than anticipated to get to the next stage for whatever reason, you may find that it would be better to get two times money now and exit to another firm rather than waiting three years to get four times money.' This approach may not return the most money to investors over the long term, but it will return it earlier and provide them with some liquidity.

In fact, liquidity is a key issue here. One of the reasons public markets are so liquid is because it is easy to trade shares. A secondary buy-out in the private equity market is one of the mechanisms firms can use to improve liquidity in what is a comparatively illiquid market. Most firms would argue that the issue of who is buying and selling should make no difference to the deal, as long as it's a good one.

‘We don't have great rules about when we'd exit via a secondary buy-out,' says Heywood. ‘We're simply trying to sell to the highest bidder to ensure that we get the maximum return. When we're buying, we focus on the company. That's what is important to us. Obviously, we want to know why the investment is being sold whoever is selling it, but we understand that there is a natural life to an investment and that private equity houses have to exit at some point. We focus on the company and on what kind of investment it would be for us.' Maxwell agrees. ‘The source of the sale shouldn't be the issue, it should be the dynamics. It doesn't matter whether you buy from a trade vendor or another private equity house, as long as the business is sound. After all, trade sellers buy and sell from their competitors. Why shouldn't private equity firms?'

The risk factor
There is also the argument that secondary buy-outs are less risky deals than other types. Trade buyers, for example, are far less experienced in doing deals than private equity houses. ‘A trade buyer's main focus is on making widgets or whatever,' says Marshall. ‘There is a danger that they don't have the money on time or are too busy working out what to do to respond very quickly. Venture capitalists do deals for a living. They know what they're doing.' The seller may also have an insight into how the other firm does deals and be able to structure it accordingly. ‘You'll know whether they're the type of firm that tries to cut the price at the last minute or whether they stick to their price - that's good to know in advance,' says Marshall.

Buyers, on the other hand, should feel pretty secure in the knowledge that the company they're buying has sound governance and financial systems in place - these will almost certainly have been put in place by the previous private equity firm. The company's management will also have been through the process before and will know what to do and what to expect. This is probably less of an advantage at the larger end of the scale, where growth is arguably harder to achieve than in smaller companies that are likely to have a higher growth potential. ‘If you're a buyer in these situations, you have to have another plan,' says Smits. ‘If one firm buys from a corporate and then implements good financial systems and internal management, that will increase the value of the investment. If you're buying that business, you have to be sure that it's going to have tremendous organic growth because there is little that you can do to improve its systems.'

Granted, not all secondary buy-outs are going to be resounding successes for investors - some undoubtedly won't be. However, this type of exit is dependent not so much on who is buying and selling, but more on the quality of the underlying company. At first glance, the increase in secondary buy-outs may look rather like a club of private equity professionals passing on indifferent investments between each other. In fact, they are an inevitable consequence of a maturing industry, one that is increasingly segmented and investing strategically. In many cases, a private equity firm is quite simply the best buyer for a particular business, either because of the reduced risk involved in dealing with other private equity firms or even because the prevailing economic conditions mean that alternative exit routes are not feasible. What is certain is that secondary buy-outs can help create an increasingly liquid market - something investors should welcome. ‘It's a natural part of a more competitive market,' says Maxwell. ‘If the private equity market wasn't looking at itself as a source of deals, then we would be a lot less smart than we think we are.'

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