Secondary, tertiary and even quaternary buyouts continue to grow in popularity. According to data from SCM Strategic Capital Management, unsurprisingly, the secondary buyout was the most popular exit route in Europe, showing a 41% increase in 2004 compared to 2003. No other exit type in Europe has generated more distributions to investors than secondary buyouts. Probably the biggest challenge investors are facing with these transactions is the incentivisation of the management team. Angela Sormani reports.
Where five years ago a secondary buyout wouldn’t happen unless management rolled over 100% of its interest, in the last 18 months a 50% roll over has become the norm. Players are saying one of the ways to make sure a secondary or tertiary bid is successful is to agree for the management to roll-over less so their wealth becomes not just paper but banked and so they support the bid. But with management holding less of an equity stake in the business, the issue for private equity firms is how to make sure the management is incentivised enough to continue to drive the business forward.
Management’s stake in a business is crucial as management’s involvement may after all turn out to be a variable factor in the likelihood of the business to perform or outperform, or not. Rod Selkirk of Hermes Private Equity, which has been involved as both a buyer and seller in secondary and tertiary transactions, says: “The main challenge in a secondary buyout is how motivated and incentivised the management team you’re backing is.”
The main issue a private equity firm comes up against when buying a business at a secondary or tertiary stage is the level at which it feels comfortable for management to swap equity for cash.
Hermes sold Merlin Entertainments in May this year to Blackstone Capital Partners in a £102.5m tertiary buyout transaction. Hermes Private Equity originally acquired the business in February 2004 for £54m in a secondary buyout from Apax and JP Morgan Partners. That consortium paid £47m for the attractions business which was bought out of Vardon in a leveraged transaction in 1998. Hermes made a two and half return on the deal in 14 months.
Selkirk says: “When we bought Merlin, the management hadn’t made as much as they would have liked in the buyout the first time around and were very committed to the future growth of the business. When we acquired the business, management did not realise a huge amount from the deal. And when we sold it to Blackstone there was still more to be done with the business. Blackstone has since acquired Legoland and is continuing expansion of the business in a way that would have been challenging for us to do.”
More recently Hermes Private Equity backed The Works, a value retailer of books and artist materials, in a £50m secondary buyout from Primary Capital, which had backed the original buyout in 2003 for an undisclosed sum. Selkirk says: “The Works was slightly more difficult because the management team had already made some money. However, they were prepared to invest a substantial proportion of their sale proceeds in equity in the deal that we backed. The management team ended up with a very significant stake and are highly motivated and incentivised with the structure.”
Selkirk says it is challenging to back a secondary buyout where one of the drivers of the transaction is cash out to the management team. “The problem comes if the business runs into difficulties, not when it is doing well. That is when the commitment of a management team is truly tested. If a management team finds itself where its equity position is underwater but where the team members already have tens of millions of pounds in the bank from previously selling the business, then that can be a challenging dynamic.”
He adds: “The equity percentages are purely a question of economics. It depends on the debt structure of the deal and how much the private equity firm puts in. It’s mainly a question of what’s a good deal in terms of our returns and a fair deal for management in terms of their returns. We don’t like ratcheted transactions; the simpler the deal, the better.”
In another scenario, management might easily be in a position where it has taken a lot of money out of the business, but still holds onto a good stake. That stake isn’t necessarily diluted because you want the management team to retain a significant stake to remain incentivised.
Simon Wildig of Close Brothers Private Equity (CBPE), which has experience of such transactions with the secondary buyouts of Hillarys Blinds and Park Resorts, says: “The biggest issue with secondary buyouts is the incentivisation of the management team going forward. If you’ve got a successful management team with millions of pounds of value stacked up for them, it can still work. I think it’s very important that secondary buyouts do have that management incentive in place. I would say they need to have the majority of their value locked in and see the opportunity to treble or quadruple it over three to four years to make it worthwhile.”
Park Resorts was sold to ABN AMRO Capital in January this year for £165m. The transaction saw Park Resorts combined with GB Holiday Parks, owned by ABN AMRO Capital, to create the UK’s second largest caravan park groups, with 35 parks. The Park Resorts management team, led by chief executive David Vaughan, took on the management of the combined group. The sale marked CBPE’s most successful investment, with the firm achieving a return close to eight times its original equity investment of £12.25m and an IRR of over 80%. CBPE reinvested £10m of the proceeds for a minority equity stake in the combined business.
CBPE sold its 45% stake in Hillarys Blinds in August 2004 in a £115m secondary transaction to Change Capital Partners. Close Brothers Private Equity VI made a 4x return on the sale. Founder Tony Hillary sold his 10% stake in the business and the management team sold its 45% stake but reinvested a portion back into the company to acquire an undisclosed minority stake.
Private equity firms have learnt to be a lot more comfortable crystallising value for shareholders in these types of transactions, because they have had to. Most firms are more willing to put some money in manager’s pockets to sweeten the equity and without diluting their own share.
Dominic Ely of Investec says: “Private equity houses have increasingly got comfort that you can put some value into people’s pockets as long as you continue to incentivise them properly going forward. If you’re backing the right sort of people it’s not just about the cash; it’s about a new and attractive investment strategy that will generate good returns for all shareholders.”
As management becomes more experienced with this type of transaction a new phenomenon has been noted among the private equity community; the own management buyout (OBO.) The general idea is that management evolves with the business and also with the size of the funds investing in the business. Chris Masek of Industri Kapital explains: “The third or fourth time round management has earned enough money and is sophisticated enough to go and see the banks or even the fund-of-funds to invest with them and they then take control of the business themselves with the investment having gone full circle.”
But each case is different. In general, the amount of money being made the second time round is significantly greater than the first time. The reason being that management has made some money and is able to invest more into the business.
Gareth Healy of Close Brothers, who recently advised the management of NCP on its £555m sale from Cinven to 3i, says: “These deals are hugely competitive and one of the key swing factors can be the management package. This is about management maximising their position and what management teams are now realising is just how much power they’ve got. For them, staying in the original deal can actually be more lucrative in the long term but they do need an attractive deal to make them agree to the sale. Packages available to management now are very different to what they were a few years ago. If properly advised, management can utilise the leverage they have in the transaction to significantly enhance their position. There’s so much at stake for them as the potential can be there to change their lives if they get it right.”
Healy also advised Gala Group on the sale of a £200m minority stake from existing investors Candover and Cinven to Permira, valuing Gala at £1.89bn. Permira became a joint and equal investor in Gala alongside Candover and Cinven. He says: “Gala was the UK’s first quaternary deal. The issue here was ensuring that the company had the right partner to develop the business further. In this instance, the new partner on board, in the form of Permira, will enable the company to do more M&A, but with the same management team and management incentive structure because the company hasn’t been sold. On the management side, it is business as usual. And as the management has the same economic interest as the private equity house, it is more likely to drive the business to succeed.”
A refinancing of the company’s debt has also been undertaken as part of the restructuring and was arranged and underwritten by Royal Bank of Scotland and Lehman Brothers. Close Brothers had maintained a relationship since advising management at the time of the tertiary buyout in 2003.
At the end of the day, the difficulty in a secondary buyout is not whether you’re buying from another private equity firm, the issue is which management team you are backing, what stake in the business they hold and what their motivation is and that’s where the sensitivity should lie.