Emily Dickinson once wrote that “Fortune befriends the bold”. But can secondary buyouts (SBOs) be considered a bold decision? This flight is going to take you over the SBOs of today in the hopes of giving you a good understanding of the concept and performance drivers of these transactions. This being said and without further ado, enjoy the flight.
SBOs refer to the sale of a portfolio company by one financial sponsor or private equity firm to another. This transaction marks the end of the seller’s control or involvement with the company.
Historically perceived as panic sales, – situations in which companies sell assets at significant discount to avoid financial distress – they have been on the rise in the past couple of years, and, according to some sources (such as Pitchbook), the share in the relevant market amounts to up to 48% of all private equity exits. This popularity can possibly be explained by the gains from higher leverage, better financing conditions, a faster deal process and the already verified solidity of the investment through the seller in this “second-hand” deal type.
But these buyouts can make sense for both the seller – when the firm realises gains from the sale of the investment – and the buyer – when the buying firm can offer benefits/ synergies to the entity being sold. Although SBOs and Initial Public Offerings (IPOs) are both considerable exit strategies, SBOs allow the seller to forgo having to fulfil the complex regulatory requirements and lock-up periods that come with an IPO while having similar to a trade sale range of buyers in an auction process.
Enjoy the flight
Is the rise of secondary buyouts good news for investors?
Han T.J. Smit and Vadym Volosovych explain the two main scepticisms of researchers and practitioners on the recent SBO trend. First, SBOs’ potential of operating performance can be limited due to implemented improvements by previous PE owners. Second, SBOs can potentially be overpriced because PE valuations are inflated by PE fund inflows in a phenomenon known as “money chasing deals” – Gompers and Lerner research tells us that inflows of capital into venture funds increase the valuation of these funds’ new investments.
So, given these considerations and scepticisms, why should a PE firm perform an SBO?
Yingdi Wang identifies 3 main reasons:
- Efficiency gains – which happen primarily in primary buyouts but can also be included in SBOs. It might still be possible to derive value from high leverage, improved governance structures, and operational engineering.
- Liquidity-based market timing – this means that the SBOs can be carried out with a purpose other than the continued improvement of the target firm: they can be “by-products of capital market conditions and private equity firms’ incentives to exit deals quickly” (possibly due to the finite life of funds).
- Collusion motive – this implies that SBOs are the result of a number of factors in the market that create a favourable environment for trading assets. Examples of these factors can be the lack of regulation and the possibility of portfolio companies being traded among a limited number of private equity companies.
Let us now look into some performance drivers for SBOs.
Data seems to back up the idea that SBOs tend to underperform PBOs and research made by Tjark C. Eschenröder shows us that SBOs have significantly lower sales and asset growth rates over the investment horizon. But why does this happen and how can we spot a possibly low/ high performance SBO?
Francois Degeorge, Jens Martin and Ludovic Phalippou (2013) analyse three potential explanations for the underperformance of such large category of private equity investments:
- Significantly limited value gains for the buyer of an SBO
- Agency problems between private equity funds’ managers and investors that generate an incentive to overpay for SBOs
- SBOs are less risky
They find evidence for the “go for broke” hypothesis of Axelson, Strömberg and Weisbach (2009) which shows that fund managers sometimes overpay for transactions occurring at the end of their investment period. They find that the Cash Multiple of “late-bought SBOs” is lower by about 0.8x. As the average cash multiple is about 2.1x – over one third less capital is returned to the investor when a buyout is made towards the end of a fund’s investment period.
This means, according to Degeorge et al., that SBOs could be “natural investments for funds who want to spend money fast while limiting downside risk”, because they already had committed capital and have the incentive to spend it all before the end of the investment period. The takeaway is that SBOs performed late in the buying fund’s investment period tend to underperform when compared to similar PBOs. Moreover, there seems to be a positive relationship between the size of the SBO relative to the fund size, and the underperformance of the SBO – the bigger the relative size of the SBO when compared with the respective fund size, the higher the probability that the SBO will underperform.
Pretty intuitively, there’s also evidence that SBO buyers perform better when sellers are under pressure to exit their investments: “SBOs purchased from private equity firms that are fundraising at the time of the transaction outperform other SBOs”. This can be seen as the flip side of the “go for broke” situation – Buyers of SBO achieve an extra 0.9 of Cash Multiple when they purchase a portfolio company from a fund-raising seller.
Degeorge et al (2015) also found another important determinant for value creation in SBOs. They describe it as the “complementary skill sets between the buyer and the seller”. To put it in other words, SBOs tend to demonstrate superior performance and value creation for investors, if they occur between a PE firm focusing on margin growth and another focusing on sales growth, or between two PE firms in which the partners have complementary educational backgrounds or careers. There are also good prospects of value creation for SBOs when global funds buy from a regional fund. This is also true when SBOs are bought by more specialised funds.
Looking at research, it is pretty clear that there are numerous reasons for an SBO. Nevertheless, there have been some concerns starting in 2019 as the number of secondary buyouts worth at least $1bn was roughly 50% lower than in the previous year on a global level (Pitchbook). Still, the overall share of SBOs remained fairly stable and just below 30% globally in 2019 despite less PE exits. In Europe the exit route remained fairly popular in 2019 (Bain). 2020’s frequent disruptions hit the PE deal flow hard as increased uncertainty in pricing and difficulties in the due diligence processes decelerated overall deal velocity leading to a lower number of SBOs, albeit the overall share of SBOs remained high (EY).
The evolution of SBOs includes many prestigious names of the PE world, global brands, and market leaders as targets, since the former have superior borrowing capabilities and the latter have a specifically high tolerance for leverage as they generate cash from a strong market position.
A few interesting deals over the last couple of years can serve as exemplary cases for this observation and are further explored below – together with some noteworthy trends over the last years.
Simmons Bedding – cash under the mattress?
One of the most notorious and certainly not the example par excellence is Simmons Bedding, one of the world’s largest mattress producers – US maker of the Beautyrest brand. Its complex history with financial sponsors started in 1986, when the private equity firm Wesray Capital owned by former Treasury secretary William E. Simon entered with a $120m deal and made a profitable exit through an Employee stock option plan in 1989.
In 1991, it was the turn of Merrill Lynch Capital Partners with a majority stake for only $32m, which passed it on to Investcorp in 1996 for $265m. Two years later, it went to Fenway Partners for $513m. After a successful launch of the innovative no-flip mattress and subsequent operational improvements Simmons was sold to Thomas H. Lee for $1.1bn in 2003. However, the operational success did not continue and the recession after 2007 also took its toll on the firm, resulting in a distressed sale of Simmons for $760m to Ares Management – owner of mattress giant Serta and Teachers’ Private Capital (PE fund of Ontario Teachers’ Pension Plan) including subsequent restructuring through chapter 11 that halved the outstanding debt.
In 2012, Advent International joined the party with a majority stake in Serta and Simmons for over $3bn while the other parties retained minority interests. In 2020, the COVID-19 crisis led to cash shortages making a debt restructuring vital for Serta. However, creditors clashed as hedge fund Apollo sued Advent and mutual funds also holding debt from Serta over the restructuring procedure.
This case exemplifies many of the characteristics that secondary transactions define. Firstly, the mattress companies are prime targets for sponsors as they offer stable cash flows and predictable growth – important qualities for the increase of leverage that is necessary to make secondary buyout profitable. Furthermore, the history of Simmons can easily be construed as a form of “passing the hot potato” which constitutes a common accusation against secondary transactions. It certainly had negative implications for the firm’s economic health and the employees of the company being under the ownership of 6 financial sponsors in a row over the period of nearly three decades, resulting in a substantial restructuring during the crisis in 2007 and multiple job losses. However, it also shows that both operational improvements and profitable strategy realignments such as the combination with Serta are possible under PE ownership of secondary bought targets. Moreover, the current impact of COVID-19 on businesses also affects PE firms indirectly through restructurings and their legal implications.
Lumenis – a beautiful entry
The Israel-based medical and aesthetic laser company Lumenis was acquired via a $510m public-to-private transaction in 2015 by XIO group – a Chinese PE fund based now in London with a mysterious investor base that was only founded in 2014 in Hong Kong. In an article of the WSJ the company’s acquisition of JD Power brought to light some concerns about XIO’s sources of funding unknown to both XIO’s employees and JD Power’s executives. In 2019, the sale of Lumenis to Baring Private Equity Asia made for another rarity as the SBO with a deal value of $1bn was one of the few SBOs above $1bn in 2019. This highlights that also newcomers are involved in SBOs.
Ancestry.com – quality growth targets
The US-based Ancestry.com, an at-home DNA testing kit seller and service provider competing with 23andMe Inc., was taken private in 2012 by Permira and sold in 2016 for $2.6bn to Silver Lake and GIC. Permira still holds a minority interest in the genealogy website in 2020 when Blackstone acquired a majority stake of about 75% for $4.6bn. The deal is not only fairly sizable but also an investment in the life science industry – a still young industry with a more aggressive growth profile – that reveals tendencies towards a riskier group of targets.
LGC – a future technology treasure
LGC, a UK scientific measurement and testing company in the life science space – and a high-growth player generating over 10% p.a. organic revenue growth from 2016 to 2019 – has a repeated history of secondary buyouts. It was acquired by Bridgepoint in 2010 for around €283m and sold to KKR for around £650m in 2015. In 2019, again, PE funds were interested, including big names such as Blackstone, Carlyle, Advent and EQT. Eventually, Cinven and Astorg as well as the sovereign wealth fund Abu Dhabi Investment Authority paid £3bn for the laboratory service company. This constitutes a more than 3x investment gain for KKR and points to highly profitable opportunities within the SBO exit market even in 2019.
As we prepare to land, we figured that what used to be considered a last resort in terms of exit strategies, nowadays appears to have become a plausible value creation tool for private equity and venture capital companies.
Despite all the scepticism demonstrated by researchers and practitioners – such as the limited potential and overpricing of SBO’s – it seems as though there are good reasons to perform these transactions. From this set of good reasons, we can derive: the (still possible) efficiency gains; and relatively high liquidity of these investments, that along with a perceived low risk, make this exit strategy appetising for funds that are reaching the end of their finite life.
This being said, the development over the last two decades suggests that SBOs will remain popular exit strategies for PEs and VCs. Similarly, to secure touchdowns of airplanes, successful closings of SBOs require clear and sound conditions. As market conditions recently deteriorated, so did deal flow between sponsors. Additionally, the US PE market saw a burgeoning IPO and SPAC market in 2020 that strengthened the position of public exits vis-à-vis SBOs in terms of deal volume as seen below.
Moreover, looking at companies with intensive private equity involvement, one can easily find instances where restructurings were necessary despite established operations and market positions. However, SBOs can be successfully executed even in highly volatile, fledgeling industries and operational improvements are not confined to a single sponsor. SBOs can provide a safe exit route to both experienced and young PE funds if handled with care and given a certain asset quality – not exactly the emergency landing on the Hudson River but rather the go-around to avoid more serious trouble.
Yingdi Wang, “Secondary buyouts: Why buy and at what price?” – page 1307 – Journal of Corporate Finance (year 2012)
Han T.J. Smit and Vadym Volosovych (year 2013), “Secondary Buyout Waves” – pages 2, 6
Paul Gompers and Josh Lerner, “Money chasing deals? The impact of fund inflows on private equity valuations” – pages 321, 322 – Journal of Financial Economics 55 (year 2000)
Tjark C. Eschenröder (year 2020), “Secondary Buyout Performance” – page 46, 47
Francois Degeorge, Jens Martin and Ludovic Phalippou (year 2013), “Is the rise of secondary buyouts good news for investors?” – pages 1, 3, 5, 6, 14, 17
Francois Degeorge, Jens Martin and Ludovic Phalippou, “On secondary buyouts” – pages 130, 131, 134, 138, 139, 140 – Journal of Financial Economics 120 (year 2015)
Stefano Bonini, “Secondary Buyouts: Operating Performance and Investment Determinants” – pages 431, 449 – Financial Management (year 2015)