Secondary buyouts: the new stock market?

In many players’ minds, the secondary buyout phenomenon has replaced the IPO as a major means of exit for private equity firms. As Chris Masek of Industri Kapital says: “Secondaries are now a fact of life primarily because stock markets aren’t really there for us anymore. We have become the stock market. We’re replacing a vacuum that’s been created. You just don’t get IPOs of mid-sized companies any more and so a chain has been created.”

Unlike IPOs, secondary buyouts can be a relatively quick and easy way of exiting an investment to a buyer experienced in the M&A process. An added advantage is that buying from another private equity firm means buying a cleaned up company. You might buy the company at a higher price, but at the same time you get a better quality company. Also in a secondary buyout, the protection for the VCs and the LPs is that the management normally invests more of its money. In the first buyout management might have invested hundreds of thousands, but the second time round millions are often at stake.

Secondary buyouts first made a dent in UK exit figures in 2002 with 65 secondary transactions, almost double the 35 of the previous year, according to the Centre for Management Buy-Out Research (CMBOR.) Since then secondary buyouts have become firmly entrenched as a main exit route for private equity houses. The number fell slightly in 2003 to 63 deals, but secondary buyouts were back in force in 2004 reaching a record of 85, equating to an eighth of all UK buyout transactions for 2004. At £7.1bn, the total exit value for secondary buyouts was also a new record, well above the previous high of £4.4bn reached in 2002.

The main issue surrounding these investments is whether LPs express a negative view of selling to and buying from other private equity houses. In the past LPs have viewed secondary buyouts as GPs shuffling assets among themselves, consolidating their own gains at the expense of investors who might be present at both sides of the secondary buyout and many believe investors aren’t getting a true realisation if they are present in both funds.

Research from Standard & Poor’s highlights the secondary buyout of Gala Group as an example of the potential carve-up of future equity gains between private equity investors. Following its original buyout from Bass in 2000, when CSFB Private Equity and PPM Ventures paid £400m for the business, the group increased its enterprise value by growing revenues organically and improving margins, as well as by buying and integrating a portfolio of casinos formerly owned by the Hilton Group, for which it paid £236.7m.

At the time of refinancing Gala was on track to attract further investment in light of UK gaming market deregulation. Some benefits offered by this deregulation, a relaxation of casino membership rules and the opportunity to advertise casinos, for example, were quite certain, while others, such as the limits on slot machine jackpots, remained less so. The price of the secondary buyout duly reflected these risks and opportunities.

The business was sold in February 2003 to Candover and Cinven for £1.24bn, a price premium of about £400m after additional capital expenditures. Two years on from the secondary buyout, Gala looks slightly less attractive as an IPO prospect, given that the pace and outcome of UK gaming deregulation gave fallen below expectations. But the business remains highly cash- generative with a strong market share in UK gaming, which would be attractive to an international gaming operator.

But most private equity firms maintain they hear no negatives noises coming from their investors. Most LPs are aware of the importance of secondary buyouts, especially in uncertain market conditions, in allowing private equity firms to clear their decks for potentially more lucrative investments in upcoming investment cycles, something beneficial to their LPs in the long term.

Indeed some LPs even consider secondary buyouts better deals. This is reflected in the jump in the number of these transactions. Surely if LPs were that unhappy about these investments, the figures would not have not shown such a marked increase?

Peter Taylor of fund-of-funds manager HarbourVest says: “The challenge with secondaries is that there’s no low-hanging fruit anymore: the ‘first’ buyout manager will have taken care of that. You really need a unique angle on a secondary; a strategy to enter adjacent markets or product segments, or build through pre-identified acquisition targets, to make it work. But if you’ve got that angle you can make very attractive returns.”

As the boom in secondary buyouts has been relatively recent, it is probably too early to forecast returns. But you only have to look at examples, such as EQT’s return on its sale of Sirona Dental Systems to Madison Dearborn Partners, to find good performance. The transaction is the third time the business has landed in private equity hands. EQT originally invested €417.5m in the business in 2003 and although the return on the deal was undisclosed, rumours in the market marked the deal a success.

In some cases the returns made have been stellar. Travelex is proof of this. In January 1999, 3i paid £24m for a 32% stake in the company and management held the remaining 67%. In March this year, Apax Partners purchased a 63% stake in the business, valuing the company at £1bn. While the holding period couldn’t be described as short at six years, 3i received £217m from the sale, nine times the original price of its stake. Between 1999 and 2004, revenues increased five-fold, while EBITDA trebled and further growth is expected from more bank outsourcing contracts.

3i is a name that crops up on both sides of the secondary buyout market. The firm recently sold its 21.6% stake in baby care product manufacturer Cannon Avent Group to Charterhouse Capital Partners in a £300m transaction. 3i originally invested £5m of growth capital funding in Cannon Avent in 1995 in exchange for a minority stake. 3i will receive proceeds of around £64m from the sale, representing a money multiple on its investment of 13 times and an IRR of 35%.

Andrew Harris of law firm DLA Piper says: “3i is interesting because they seem to have adopted a strategy of disposing of their minority and smaller investments and moving up the scale.” So you see the firm on the sell- side divesting lower- mid- cap companies, such as furniture group SIA to the likes of mega buyout firm Industri Kapital, and on the buy-side buying solid mid-market retailers like Hobbs from classic mid-market firms such as Barclays Private Equity.

Thomas Kubr of private equity asset manager Capital Dynamics stresses there should always be a step up the ladder in such transactions: “Each time you have a change in ownership that gives a change in direction, it can only be positive for a company. Also a lot of these secondary trades are to different types of organisations. You don’t often see KKR selling to the likes of Blackstone, it’s more 3i selling to the likes of CVC.”

But Adrian Johnson of Legal & General Ventures (LGV), which has completed a buyout from other private equity shareholders on average in one out of four of its recent deals, warns: “You have to be sensitive to the views of LPs. One knows of circumstances where an LP gets a phone call from a GP with the good news that they have an exit, only to get a phone call the next day from another GP wanting to draw down funds for the same investment. It can have mixed messages.”

Thomas Kubr says the firm doesn’t have any fundamental problems with secondary deals if they are properly done and are a result of two individual firms both trying to improve their returns. He says: “They are a natural evolution of the industry going forward. As far as returns are concerned, if they’re going the secondary buyout route, they must be getting better returns than the IPO or trade sale option. The only reason LPs might be unhappy with secondary situation is if the GP abuses the technique;, for example, trading companies just so they can exit tail- end portfolios. But for the most part, it is more a theoretical fear than a practical fear.”

The secondary buyout market is here to stay driven mainly by a lack of investment and exit opportunities. DLA Piper’s Andrew Harris is confident this can only be good news for the private equity market: “The fact that secondary buyouts have become an accepted exit route is a natural consequence of the fact that private equity is now considered to be a mainstream pool of capital.”

Adrian Johnson at LGV agrees: “There’s no doubt the secondary buyout market is here to stay, but you have to be very selective as to what would make a good target, and a key component in this is the management story. The overall message is that from the sell-side the secondary buyout phenomenon is very good news. On the buy-side you have to execute such transactions with a considerable amount of caution.”