Secondary buyouts dominate PE exits
September 2017 | SPECIAL REPORT: PRIVATE EQUITY
Financier Worldwide Magazine
September 2017 Issue
The current private equity (PE) market is active as ever. Most recently, this has been highlighted by the envisaged €5.4bn takeover of German pharmaceutical company Stada by Cinven and Bain Capital. While attractive targets remain scarce these days, larger amounts of committed funds are available, waiting to be invested. Competition among PE players has become fierce.
In this market environment, selling on to other financial investors is the flavour of the month, and secondary buyouts have become the preferred exit option for PE investors. The trend culminated earlier this year when, within a single week, DBAG divested three portfolio companies to 3i, Capvis Equity and Oakley Capital, respectively. Also, tertiary buyouts are not uncommon and even quaternary buyouts have been seen in the market.
Traditional PE exit strategies comprise IPOs and trade sales, often pursued in parallel. Such dual track proceedings create competition and enable the exiting investor to eventually decide for the most profitable exit without losing time on the process.
The IPO option, with its lengthy and regulated process, however, is often not the preferred exit scenario. Limited market windows, combined with significant volatility, often infringe the respective investment cycle. Also, lock-up obligations, usually required by underwriters, speak against an IPO exit. The PE fund would have to keep a significant minority stake that can only be reduced through subsequent sales over time. The result is a staggered pay-out to the fund’s investors over a prolonged period and remaining exposure to market risks and general volatility.
A trade sale can avoid these downsides. In such an exit scenario, strategic investors often lose out against financial investors competing for the same asset. There are various reasons for this. In recent years, due to the scarcity of suitable targets, PE funds have had to pay high prices for the portfolio company they now hope to divest. As a result, even higher prices are demanded. Strategic investors often do not see themselves in a position to pay such multiples. With management, particularly of listed companies, facing increased scrutiny and pressure from stakeholders, it becomes increasingly difficult to justify acquisitions with a purchase price resulting from fierce competition rather than a more technical valuation. Further, divesting financial investors cannot accept the classic risk allocation models that strategic investors are looking for in a transaction. Typically, PE sellers offer little to no protection under the transaction documents. This gap needs to be bridged by warranty and indemnity (W&I) insurance. Although it is also being considered by exiting strategic investors, W&I insurance, in a more traditional environment, is still not perceived as adequate protection, especially in cases where only limited due diligence is accepted. Furthermore, PE funds are often not prepared to accept any antitrust risk, but require full deal certainty. Hell or high water clauses, combined with break fees, let many strategic investors shy away from a transaction. Eventually, there is also a more general angle to this. In the current market environment, many strategic investors are putting an emphasis on aligning portfolios and focus on their core business. Often they can be found acting on the sell side, putting targets on the market.
This situation pushes for secondary buyouts. A limited number of attractive targets, large amounts of committed capital and attractive lending terms with (still) low interest rates put PE funds in pole position among potential buyers. Rather than keeping their powder dry, they are often willing to pay the multiples that strategic investors can no longer get approved by their boards. Being accustomed to PE deal terms and risk allocation models helps win the race.
Sceptics may question how passing on a portfolio company from one financial investor to the next could help create value, especially, but not only, for the acquiring fund. The heyday of mere financial engineering is over. PE investors are back to the roots of their business model, adding value by reorganising and developing a portfolio company. Secondary buyouts are often a financial investor’s first step, followed by combining the target with a complementary portfolio company, using sector expertise to build a larger and more profitable business. In other cases, the portfolio company might have outgrown the seller’s target zone, thereby fitting into the investment focus of the acquiring fund.
Finally, the management of PE portfolio companies has often learned to appreciate the benefit of remaining PE controlled. Instead of perceiving a secondary buyout as simply ‘passing on the parcel’, a portfolio company’s management, in many cases, actively supports the sale to another financial investor. The managers appreciate the greater degree of operational independence resulting from PE structures and prefer it to the day to day business in large conglomerates; not to mention the PE typical attractive incentive structures.
This all makes clear why secondary buyouts currently dominate the market for PE exits. As long as these conditions persist, secondary buyouts can be expected to remain the preferred exit option in the PE market.
Michael J. Ulmer is a partner and Mirko von Bieberstein is an associate at Cleary Gottlieb Steen & Hamilton LLP. Mr Ulmer can be contacted on +49 69 97103 180 or by email: firstname.lastname@example.org. Mr von Bieberstein can be contacted on +49 69 97103 204 or by email: email@example.com.
© Financier Worldwide
Michael J. Ulmer and Mirko von Bieberstein
Cleary Gottlieb Steen & Hamilton LLP