By Eric Peghini
“Everyone has access to information. We just know how to analyze it better.”
This is the mantra of Billions protagonist Bobby Axelrod, a fictional hedge fund manager who’s ethically compromised fund breeds alpha like a wolf pack.
However, putting aside any insider trading and market manipulation, is this also the mentality of the PE funds that acquire current portfolio companies from other PE funds? To rephrase: do these secondary owners “have access to the same companies” and “just know how to manage them better”? If not, how do they create additional value? Why are such portfolio firms targeted? How are they targeted? What are the returns of repeat sponsorship? And why would the original holding fund sell to another PE in the first place?
In reality, sponsor-to-sponsor deals are quite common. In fact, in many cases the traditional growth progression of a firm involves multiple financial sponsors. The journey of a startup may begin with angel investment leading to VC funding, then growth PE sponsorship potentially followed by buyout sponsorship. In this case, each investment phase offers a unique development facility. For the uninspired, think of sponsors as the Village People; each member wears a different hat. If distressed funds are the firemen of the PE world, then angel investors are goldminers (identifying targets), VCs are talent agents (providing opportunities), growth funds are farmers (developing targets) and buyout funds are renovators (adding value). Naturally, these roles are not rigid or mutually exclusive, but they do demonstrate how the different sponsors supplement target companies in their own way.
In this article, we focus on fund managers selling controlling stakes to other financial investors i.e. farmer-to-farmer and farmer-to-renovator deals. We call these secondary buyouts (SBOs) where, essentially, two professional company builders work on the same project one after another. If the typical holding period of an asset is 3 to 5 years, it begs the question, what is left in the pre-owned portfolio company to improve for the second investor?
For one, the main source of ROI could be via a deleverage effect and/or multiple expansion which does not even require growth or fundamental improvement. Assuming superb access to capital and exceptional M&A negotiating skills, improving the target becomes unnecessary. However, for an optimal return, high leverage and multiple expansion are aggressive assumptions to make when entering an investment even for the best PE funds.
Which brings us to the second, and more illuminating, point: all investments have a time horizon and while the limited partnership agreement may allow for some flexibility in term extensions, the PE fund must be dissolved within a contractually binding period. This means that portfolio companies are held until the fund’s divestment phase and not until all financial benefit is reaped. Inevitably, upon liquidation, many of these assets will hold unrealized value which can be tapped by a different investor.
Generally speaking, when the Village People play catch with an asset, with each pass there is less unrealised value for the next investor to realise. Academic work by Zhou, Jelic and Wright (2013) and Bonini (2012) support this notion, finding that average EBITDA margin growth lags in SBOs compared to primary investments.
Since 2000, the number of PE firms and PE-backed companies has increased by 189% and 364% respectively. PE is rapidly becoming a saturated market in developed countries to the extent where it is difficult to source a valid portfolio target that hasn’t had previous PE-backing. At the same time, GP dry powder levels are experiencing all-time highs meaning that PE funds have the ammunition to purchase sponsor-backed investments flaunting large price tags.
As a result, the sponsor-to-sponsor deal has become a mainstream divestment option in the PE world as PitchBook can attest to, reporting that 48% of PE-backed exits in 2018 were SBOs. These deals come in all shapes and sizes with the largest sale-to-GP exit in 2018 being BMC Software from Bain and Golden Gate Capital to KKR for $8.3bn.
Source: Global PE Report 2018, Bain & Company Inc.
To further prove the point, sponsor-to-sponsor exits were the second largest channel by value in 2017 (and in most years since 2002) eclipsing even IPOs. The malaise surrounding IPOs as an exit strategy may emerge from the high level of market uncertainty that accompanies them, and right now the sale-to-GP channel inspires greater confidence, as the PE market is exceedingly liquid. Therefore, SBOs serve as a convenient avenue for sellers.
Based on the overwhelming popularity of SBOs, we should expect that they deliver a better return than Federer on a break point. However, results are actually quite unspectacular. The yields for primary investments are far more lucrative, outperforming SBOs by 10% to 15% on average since the financial crisis. Nevertheless, it should be noted that the best SBOs are competitive with top performing new issues. Overall, the advantage of SBOs becomes more evident when looking at risk-adjusted returns. If its capital structure remains unchanged, it is undoubtedly safer to acquire an established company that has been streamlined by a sponsor than to place a bet on a new and perhaps unknown target. Shifting from tennis analogies to golf: while SBOs offer fewer birdies, they should also provide fewer bogeys and more greens over time.
A conspicuous explanation for mediocre returns is the entry price. Realistically, given that a PE fund’s cardinal mandate is to maximize returns, primary sponsors will attempt to sell investments at high multiples. Much to the secondary sponsor’s dismay, this reduces the probability of multiple arbitrage for the SBO buyer while also requiring more capital and/or leverage upfront, all of which diminish ex-ante IRR and increases risk. A testimony of succumbing to such overleveraging pressures is the descent of Gala Coral.
“Filler assets” and agency problems are another cause of unconvincing results. In the middle ages, monks were given daily quantities of bread and beer; any remainder left unconsumed was not offered again and this would lead to smaller rations. To avoid reductions, monks would therefore eat and drink as much as possible. Remarkably, this clarifies why the stereotypical monk is depicted as a portly drunkard; more importantly however, it draws a strong parallel to fund managers and explains why they always deploy all committed capital: any under allocation could result in less LP commitment in future. It should therefore come as no surprise that a common strategy involves funds pursuing easy and risk-averse SBOs when there is a lack of better primary investment opportunities. Another pressure for hasty SBO investment is when there’s fear of a bear market drying up PE liquidity. If one has capital today and investments are available now, then why risk waiting? A paper about SBOs explains that these tactics produce some dismal returns, stating that SBOs entered relatively late (i.e. nearer to investment deadlines and presumably motivated by agency problems) displayed a statistically significant negative coefficient on LP value.
The final reservation about SBOs, although not entirely performance-related, occurs when LPs are invested in both sponsors. This is an unenviable situation because these investors lose twice by incurring transaction fees on both sides of the sponsor-to-sponsor deal for a single investment. Yes, this does occur in practice. In fact, of the 114 SBOs investigated in this Journal of Financial Economics paper, 38 experienced “LP overlap.”
But don’t panic. LPs can increase returns by strategically investing in funds that have complementary skill sets in order to avoid no-value-added SBOs. This is because much value is created for investors when there exists an intersection of relative strengths. Say the initial PE fund boosts margins while the secondary sponsor expands sales volumes (alternatively one optimizes finances while the other improves operations), then the investment reaches a sort of Ricardian equilibrium and both sponsors derive value. In this case, the LPs suffering from overlap win alongside both funds.
It is in this that although the average SBO might display a lackluster return, fund managers should not disregard sponsor-to-sponsor deals. By avoiding the temptations of filler assets and the land mines of overvalued or debt-ridden targets, and by leveraging the benefits of complementary sponsors, under these conditions, a strong SBO can be engineered.
Editor: Stefan Larsen
Author: Eric Peghini