Private equity is a cyclical business. Portfolios are assessed in terms of equity valuations, and thus hostage to the travails of the broader economy, while the individual companies they hold are often so highly indebted that a couple of percentage points’ difference in baseline interest rates can make or break them. Private equity firms also have their own internal cycle of fundraising, capital calls, and exits. When these two cycles collide – the macroeconomic cycle of equity valuations and credit, and the internal cycle of fundraising – strange things can start to happen.
As the long job of mopping up after the financial crisis continues, many firms have old funds that are fully invested and portfolio companies that have been held longer than they might otherwise have intended – but exit opportunities are only just beginning to reappear. Big private equity-backed companies that have recently gone public, such as Nielsen and Kinder Morgan, would doubtless have done so earlier had the stock markets not been in such bad shape; corporate buyers are now reappearing, after a good year for profits, but many are still operating cautiously in light of the events of the past three years and ongoing market uncertainty, and cautious about acquisitions. PRIVATE EQUITY firms are naturally impatient to get out of their investments, knowing that IRRs are being eroded with every year they hold on to them, so that they can return capital to Limited Partners, claim their carried interest and start to raise new funds.
Meanwhile, other funds, raised during the last years of the boom, are coming up against deadlines for capital calls. No General Partner wants to truncate a fund after all the work of raising capital is completed, though reportedly Carlyle cut $600m off its Japan fund in 2009, when investment opportunities in the country must have looked barren indeed. UK firm Candover Investments announced in August last year that it was to wind down its portfolio and return cash to investors. In some cases LPs have been flexible about extending investment deadlines, but with few exceptions firms which have already raised funds are looking to invest them, and many are running out of time. The solution, for many, is to buy portfolio companies from other buy-out houses looking to exit in a secondary buy-out or ‘pass the parcel’ deal.
“This trend reﬂects an increasing number of sponsors returning to market following the downturn looking to quickly deploy capital in mature private-equity backed assets,” said UK private equity firm Lyceum Capital and Cass Business School in their Q1 2011 UK lower UK mid-market dashboard report.
The nature of the fundraising cycle is such that this can make sense for both buyer and seller, regardless of how much growth is left to be squeezed out of the underlying company. In the past week, Cinven has acquired lighting products specialist SLV from HgCapital; Carlyle took over ADA Cosmetics from Halder Private Equity; PNC picked up Environment Express, a laboratory testing equipment business, from Florida Capital Partners; Flexpoint Ford bought insurance claims service company Vericlaim from Silver Oak; and Lyceum Capital acquired UK cafe chain EAT from Penta Capital.
Last year saw 102 secondary exits in Europe with a total value of €18.8bn, up from 49 deals in 2009 adding up to €2.3bn, according to private equity analysis group the Centre for Management Buy-out Research (CMBOR), with such deals making up 38 per cent of all European private equity acquisitions.
“If you look at a slightly tighter segment, for example UK deals with enterprise values between £25m to £100m, it might be 45 per cent,” says Jeremy Lytle of British mid-market firm ECI Partners.
CMBOR data indicates 13 secondary buy-outs took place in the UK in the first quarter of 2011.
Secondary buy-outs between private equity houses have always taken place, but the industry has historically been sceptical of such deals despite their ubiquity, as it could be argued that a competent fund manager would already have exploited the low-hanging fruit of cost-cutting, professionalisation and the immediate opportunities for geographic expansion. Whether a second owner could squeeze the same rates of return from a business that had already been through this treatment is uncertain.
By the mid-2000s, with credit flowing freely, buy-out firms were able to put far more leverage on portfolio companies, enabling them to achieve high rates of return with lower revenue growth. As long as credit remained cheap, that strategy worked. Easy credit contributed to general asset price inflation, and exit multiples reached records highs – but the buyers were often not corporates but other private equity houses. Many firms, with portfolios of average assets picked up at exorbitant prices, now face a reckoning.
“The multiples that private equity has paid over the last ten years don’t reflect the underlying real value, in a non-credit bubble environment, that corporates would be prepared to pay,” says Jeff Montgomery of mid-market media and telecommunications-focused investor GMT Communication Partners.
There is an expectation that the industry is set to undergo a wave of consolidation, as firms which relied more on leverage than on management expertise fall victim to natural selection. The wave of secondary buy-outs will also subside once corporate buyers return to the market and the overhang of uninvested funds is finally exhausted.
Private equity firms judge themselves on the returns they generate for their LPs, and indeed one of the palpable benefits they generate for society is through the superior returns on capital they can offer to pension funds. So it is no surprise there has been some heated debate about the merits of secondary buy-outs for LPs. The worst case scenario for LPs is that they find themselves invested in both the buying and the selling fund – thus effectively paying hefty fees to retain the same underlying asset. This risk is heightened at the mega buy-out end of the industry, where many of the same big institutional investors are partners in a relatively small pool of top-tier funds.
“It’s a lose-lose situation for the LPs, because a lot of those deals are just not going to work out,” says Montgomery. “It is driven by the need to deploy capital, as opposed to linked to fundamental values, growth profiles of these businesses.”
Few in the industry would deny that there are times when a second private equity fund can be the best buyer for a business, particularly if it brings a new set of expertise or plans to concentrate on growing a company in a different way. For instance, a large buy-out house might take a well-run company from a country-specific mid-market fund to concentrate on its international roll-out.
“This is not a new phenomenon. The growth in secondary buy-outs reflects the trend for medium-sized private equity houses to sell on their portfolio companies to global houses as part of their organic evolution or as part of a buy-and-build strategy,” says Sachin Date of Ernst and Young.
Lytle of ECI is inclined to agree. He says: “You go into a secondary purchase with eyes open. If you are buying an asset from another private equity house some of the easy wins in terms of cost cutting and professionalisation are probably not going to be there, but that doesn’t make it a bad asset.”
But it is hard to escape the conclusion that the present wave of pass the parcel deals is taking place, in spite of relatively high valuations, in part because on the contractual structure of private equity funds, which set artificial deadlines for capital deployment and exits.
“We still see prices as being fairly high – there is still a lot of uninvested capital, that competitive dynamic hasn’t gone away,” says 3i Group finance director Julia Wilson.
Still, there is no obvious alternative to the traditional private equity fund with its ten-year lifespan. Long holding periods make it hard to assess the performance of the fund and the value of LPs’ assets. Even as the secondaries market between LPs becomes more liquid, realisations and distributions are the only way potential buyers feel confident about the value of an investment. What is more, many private equity managers cherish the pressurised, deadline driven nature of a leveraged buy-out, believing it focuses minds.
“Funds have finite lives – you can’t sit on those assets forever,” said Blackstone COO Tony James at a recent talk at the London School of Economics. “If a company is in an old fund you’re no longer able to feed it equity. You can’t just roll it forever, your limited partners don’t let you. It’s a good discipline.”
The rights and wrongs of secondary buy-outs will be debated for some time, but Blackstone does not seem too worried.