Secondary buyouts: implications for LPs?

With a surge in secondary buyouts in the UK in the third quarter, the question undoubtedly arises how to add value to these transactions. Half of the top 35 deals in the UK this year have been secondary buyouts, according to data from the Centre for Management But-Out Research and this is thought to be directly linked to the number of private equity firms walking the fund raising trail next year. Many private equity houses have been unable to find trade buyers for their investments and their need to return cash to investors has prompted a flurry of secondary buyouts.

There are legitimate reasons for secondary buyouts. A firm may not have the resources to take the company to the next stage of its development and so a sale to another private equity house is another way of adding value. West Private Equity’s recent sale of Southern Cross to the Blackstone Group is a prime example. Philip Buscombe of West Private Equity, says: “LPs have now become more comfortable with the concept of secondary buyouts. Previously the complaint might have been that the lemon had squeezed dry by the private equity house. With the size of a company such as Southern Cross, [which we held for two years] you’re barely of a size to go public, but now, thanks to funding from Blackstone, it has the opportunity to grow to a suitable flotation size.”

A recent panel at the Capital Creation conference in Cannes at the end of September analysed the risks and benefits of the growing role of secondary transactions as a private equity exit source. Rod Selkirk of Hermes Private Equity is of the opinion that there is no longer a stigma attached to the secondary buyout as long as you are cautious and do your due diligence. “I would like to be able to say that secondary buyouts are a dangerous area, don’t touch it, but if you think about it, all buyouts are secondary transactions, whether you buy a business from a family or from another private equity firm. What you do need to do is look at the motivations of the seller,” he says.

John McCrory of Westport Private Equity was slightly more sceptical however, underlining the concerns of the LP community. “There can be legitimate reasons for secondary buyouts – a firm may not have the resources to take the company to the next stage. There is no problem if there is value being added at each stage.” The problem arises, however, when it becomes pass the parcel rather than pass the baton. “As private equity becomes a larger part of the M&A market, it will have to trade within itself. Transactions will seem inferior because there isn’t an external party assessing the value,” he says. As this happens more, he suggests the private equity industry may need to develop a new set of rules to deal with the issue. “If an LP is on both sides of the transaction, it is akin to trading within a stock market with a small number of brokers – almost a cabal or cartel. Serious governance issues are raised. Integrity levels are not what they used to be and legal structures to protect you don’t work,” he says.

Selkirk disagrees: “We don’t see a cabal or cartel. There is no sense of being colleagues within the industry – it is competitive.” He concludes that LPs shouldn’t fear the secondary buyout. “GPs should keep their assets of best value and cut and run with the bad ones, but that isn’t a good fund raising platform. LPs will say, ‘tell us about your realisations’, but they should really look at the portfolio more closely and understand it.”