FW moderates an online discussion covering secondary buyouts in today’s market between Richard J. Welch, a partner at Bingham McCutchen LLP, James Goold, a partner at Jones Day, and Manuel Carvalho, a manager at Preqin.
FW: How would you describe secondary buyout activity over the last 12 months or so? What notable deals have you seen in this space?
Welch: Secondary buyout activity has definitely increased over the last 12 months. It is not unusual to see private equity funds where 50 percent or so of their acquisitions and dispositions over the last 12 months have been secondary transactions. Overall, I would say secondary transactions have represented close to a third of completed transactions, and I would expect that level to continue to increase. There have been lots of notable deals; you simply need to open the newspaper on any given day. Recently, secondary deals making news have included Getty Images, Party City and Savers Inc. These are significant deals – all over $1bn. There is a pretty constant drumbeat of activity, especially so in the middle market for deals of up to $1bn, with secondary deals getting done across virtually all industries and geographies.
Goold: Secondary transactions remain a key feature of the UK private equity landscape and a significant driver for mid-market deal activity. According to CMBOR/Equistone Partners Europe/Ernst & Young UK buyout data, in 2011 they accounted for 45 percent of all PE market activity, representing a total transaction value of £5.4bn. This momentum seems to have been maintained in the first half of 2012, although with a slight falling off of activity in the lower mid-market in the first quarter of the year, according to Lyceum Capital/Cass Business School’s UK Growth Buyout Dashboard. This is in line with our own experience. A significant proportion of the completed PE deals we’ve acted on over the last 18 months have been fund-to-fund transactions. On top of completed deals, more often than not, we’re seeing auction processes involving PE portfolio company sales which attract a large number of unsuccessful bids from PE houses, demonstrating ongoing appetite for these sorts of deals.
Carvalho: During the first six months of 2012, 160 secondary buyouts with an aggregate value of $27.1bn were announced globally, broadly keeping pace with the level of activity witnessed during the previous year when 335 secondary buyouts valued at $65bn were announced. Throughout this period, secondary buyout activity has typically mirrored the wider buyout sector, with a post-Lehman peak of $25.9bn in secondary buyouts achieved in Q2 2011 – followed by a slowdown in activity in the following months due to the re-emergence of market turmoil globally – and, most recently, a rebound in activity in Q2 2012, when 80 secondary buyouts valued at $18.4bn were announced. Interestingly, in the post-financial crisis period, secondary buyouts, along with sales to trade buyers, have maintained strong levels of activity, with fund managers and trade buyers utilising the large amounts of dry powder and cash reserves at their disposal to acquire PE-backed companies. This is in stark comparison to other traditional exit routes such as IPOs, which have struggled in recent quarters due to volatility in the public markets. Notable secondary buyouts in 2012 include the $3bn acquisition of credit data company Transunion by Advent International and GS Capital Partners from Madison Dearborn in February 2012, and CVC Capital Partners’ acquisition of technical trading company Ahlsell for $1.8bn from Cinven and GS Capital Partners.
FW: Could you outline some of the key factors driving current deals? Are PE firms using secondary buyouts as desirable exit routes, or are they considered a last resort in the absence of other exit opportunities, such as a trade sale or IPO?
Goold: It is true that there is currently a fundamental absence of IPO exit opportunity, which limits realisation options for PE investments. That isn’t the sole driver for the current prominence of secondaries, though. Despite reduced levels of warranty cover available – as PE sellers will customarily only give warranties as to title to their shares and capacity/authority to transact – secondaries appeal on the buy-side for a number of reasons: the target has been through the ‘wash’ of a previous transaction so its management team will be used to operating under a private equity regime, reducing the prospect of post buyout culture shock; also, its recent corporate activity, including bolt on acquisitions, will have been conducted under the auspices of the PE owner, which adds a level of comfort to the acquirer. On the sell-side, transacting with a counterparty familiar with the dynamics of PE sales – in particular, the unavailability of meaningful warranty cover – can remove some of the transaction risk and smooth the negotiation process. In addition, trade sales continue to provide plentiful exit opportunities in the lower mid-market, making up approximately 50 percent of the total exits in 2011, according to the Lyceum/Cass report. The result is that meaningful prospects remain for exit value enhancement through competitive bidding processes without the need for an IPO dual track. Finally, the need for certain PE houses to deploy their funds after the slowdown in transactions through the economic crisis, so they can move forward with the next fundraising cycle, seems to be leading to decent assets attracting very full prices. Exiting PE houses are able to take advantage of those dynamics to maximise returns whilst achieving the buying house’s need to get existing funds fully invested.
Carvalho: A turbulent period in public markets has left private equity firms with two viable exit routes – a trade sale to a corporate buyer, or a sale of their holdings to another private equity firm via a secondary buyout. Currently, PE firms have access to large amounts of dry powder, with buyout firms currently having an estimated $370bn of capital at their disposal to invest, much of which comes from the record amount raised by PE firms pre-crisis. Firms are now under pressure to invest that capital before the respective investment periods terminate on their funds, while at the same time providing strong returns to investors. This has led to a surge in secondary buyouts in recent years. Though the wider market has a polarised view of secondary buyouts, with commentators questioning whether such deals are positive or negative for investors, within the private equity sector secondary buyouts are generally viewed as a non-contentious and legitimate exit route. Sellers often achieve strong returns via a secondary sale, and buyers feel they can add value to a purchased company using alternative expertise that the selling buyout house may not have access to.
Welch: First and foremost, there is a huge overhang of companies that PE firms wish to sell, estimated to be in the range of 5000 to 6000 in the United States. The 2007 financing market break and 2008 post-Lehman meltdown led to low levels of M&A activity. That phenomenon continued until the high levels of PE buys and sells in 2010, which were clearly driven by concerns about the expiration of the Bush tax cuts. So there continues to be pent-up PE portfolio-company sale demand, coupled with a big capital overhang among US PE firms. Many of these companies are not IPO candidates, and certainly not every company wants to be public today anyway. With infrequent exceptions, we do not see these sales as last-resort sales. Most are auctions and, in a lot of cases, the PE firms are winning them at robust multiples for quality companies. Strategics are also stepping in and buying these companies, too.
FW: What is the appeal of secondary buyouts for the acquiring PE firm? What advantages does this model offer to the exiting seller?
Carvalho: With private equity firms under pressure to invest the large amounts of capital at their disposal, while also exiting holdings and generating returns for LPs, secondary buyouts provide a solution to PE firms looking to both buy and sell portfolio companies. Acquirers looking at another PE firm’s asset are often familiar with the asset as it is held by another PE firm, and feel they can add value to the company. In addition, it can be easier to raise capital for a secondary buyout, as lenders are familiar with the asset, a huge plus in this credit restricted era. For a seller, a secondary buyout provides an alternative exit route to the traditional routes of trade sales and IPOs, which is particularly important in the current environment where public market volatility has led to a slowdown in listings, often eliminating that option. This leaves secondary buyouts as a legitimate exit route for a seller looking to generate returns for their LPs.
Welch: In a secondary sale, the PE firm is buying a more tested business than in a typical private sale. For one thing, the company has been through a rigorous sale process. Many PE firms are very hands-on with detailed operational oversight, which certainly benefits the buyer as the risks of the business have been better managed. The exiting seller also has a buyer who is a professional acquirer – the sale process is usually smoother and almost always faster. PE firms are also good appraisers of risk – there are fewer ‘break the deal’ issues. All this creates greater deal certainty. There is no founder or owner in control of the sale process who may get sellers’ remorse. The management team is also more tested and already has extensive experience working with a financial partner. These are all favourable dynamics to getting deals done.
FW: Have you seen any recurring themes in the way secondary buyouts are being structured and financed in today’s market?
Welch: One fairly recent trend or theme we have seen is continued equity participation or ‘rollover’ of equity by the selling PE fund. These rollovers make for a much easier deal and greater deal certainty as the selling sponsor stays financially committed to the portfolio company. We have also seen more earn-outs in these deals than we used to, although these are less frequent when the financing markets are really strong because it is easier for the PE firms to make the equity returns work. As to financing, the quality of the target company is of course the key – it doesn’t matter a lot who the seller is. However, it may be more likely that the existing lender wishes to stay in the deal and if the selling sponsor’s relationship with that lender is good, that’s a leg up for the incumbent lender.
Goold: There are some prominent features we repeatedly see, including the following. First, management and seller roll-over, or ‘vendor finance’, is a common characteristic, especially in a climate when bank lending remains relatively difficult to obtain. These roll-over investments require careful consideration by the buyer, in particular in terms of intercreditor ranking and how the roll-over instruments are treated in the event of a manager seller subsequently becoming a ‘leaver’. Second, for similar reasons, i.e., less debt funding capacity in the market generally, we’re seeing more use of mezzanine facilities, the market for which has increased with the likes of Beechbrook, Indigo and Bayside being particularly active in the mid-market. Finally, tax indemnities tend not to be given by sellers and warranties are often given by management entirely on an ‘awareness’ basis.
FW: What are some of the key points that surface in deal negotiations, with the acquirer looking to minimise risk and protect future value?
Goold: Given the absence of commercial warranties from PE sellers, leaving a ‘warranty gap’, due diligence becomes a key area of focus, both through the traditional due diligence process and also by ensuring that management sellers are sufficiently ‘on the hook’ for their warranties so as to flush out any known issues through disclosure. Particular areas of identified risk might be covered by cash-secured indemnities. Some houses will give these indemnities as long as they are limited to a commercially acceptable level for the risk concerned and by a short timeframe so they don’t extend beyond the required timeline for fund distribution. The warranty gap can also be addressed through the use of tailored ‘top-up’ insurance products – warranty and indemnity, or ‘W&I’, insurance – which are now available at commercially attractive rates and on a basis that covers the vast majority of the warranties given by management. This hasn’t always been the case but the market has developed greatly in the last decade. These provide both PE and trade buyers with financial recourse in the event that loss from a breach of warranty by the managers is irrecoverable as a result of their limitations on liability. In auction processes, we regularly see these buyer-side policies being teed up by the PE seller to address this issue.
Welch: With the PE fund seller, there is real pressure on the representation and warranty survival period. The PE fund managers want to distribute the proceeds to maximise the fund’s returns and their carry and minimise any possible future buyer claims. This puts a lot of pressure on tax matters, which typically have a statute of limitation survival period, so it becomes important for the PE fund buyer to educate itself on tax matters as a shorter tax survival period is important to the seller. In general, the PE fund buyer will be less worried about risk contingencies, but a lot of that will depend on the reputation and level of hands-on involvement of the PE fund seller. Of course, in bigger deals over $1bn, where the sponsor fund has a several year investment hold, no survival deals have made their way back into the marketplace, i.e., a public company type deal is possible.
FW: What methods are PE firms using to create value post deal? Is it difficult to extract additional value where a previous PE owner may have failed?
Carvalho: Acquiring PE firms often feel they can add value to a company being sold by another PE firm, either by utilising their alternative industry knowledge, network and contacts to grow the company, or by implementing different debt or management strategies. Alternatively, the company may simply have reached a size that now that falls within their area of expertise. For example, a company bought by a mid-market specialist five years ago may have grown successfully into a large company, and the new PE firm acquirer may be more adept at growing larger companies than the original mid-market PE firm. These different qualities that each PE firm possesses lead the acquirers to firmly believe that they can provide extra value to a company that their predecessor may not have been able to add.
Welch: In almost all deals, there are a number of ongoing or unexecuted strategic initiatives to provide growth. These are operating businesses striving for growth all the time. They don’t stand still, and there always seems to be unfinished business and strategies to implement. Plus, the new PE firm may bring new relationships and management expertise, in many cases by attracting to the board industry executives who work closely with management to add value. PE firms operate differently. There is also an element in many of these deals where a larger, more sophisticated or more specialised sponsor takes control of the company that has been brought to its current level by management and the selling sponsor, and is now poised to grow to new heights. The buying sponsor also may be able to provide more growth capital and pursue a more ambitious acquisition platform strategy.
Goold: The days of being able to rely on ‘rising tide’ value accretion are well and truly over and PE houses are having to applying much more hands on engineering to their portfolio assets to maximise values. With the UK economy flat-lining, except in certain niche areas, growth has to be sought in particular through expansion into overseas markets or through buy-and-build strategies that create value through achieving critical mass. Bolt-on acquisitions make up a fair proportion of current PE activity. Where investments have been less than successful for one PE house, it doesn’t mean that the underlying asset is exhausted of potential. Change in management, bringing with it change in strategy, can often be brought about in the context of a secondary transaction leading to a second wind for the investment. Also, there is scope for additional value creation even when a selling PE house has made a decent return on an investment, but for reasons relating to fund longevity or otherwise, it doesn’t want to fund the next stage of a company’s expansion. That can happily be undertaken by a new fund with deeper pockets and investment appetite.
FW: Do you expect to see continued secondary buyout activity this year? Are any regional hotspots yielding the bulk of opportunities?
Welch: Secondary buyouts are here to stay, this year and beyond. The market is not producing enough high-quality new acquisition opportunities, so secondary buyouts will remain critical. PE firms own a lot of great companies, and these companies can continue to thrive under PE ownership. In the short-term, US tax uncertainty, pent-up sale demand and a lot of dry powder in PE firms should drive secondary deals for the balance of this year and beyond. In fact, these factors are so strongly positive that absent the macro uncertainties of the world economy, and especially Europe, I believe we would see sales volume comparable to the latter half of 2010 for the balance of this year. Industrials, technology, media and telecommunications, and, of course, energy are likely to be very active sectors, as they have been. But, who knows, and the faster European policymakers develop some real, concrete solutions, the better the secondary market will be. The financing markets have been doing their part so far this year, but the M&A market hates uncertainty, and we certainly have a lot of that now.
Carvalho: With a turbulent public equity market, it is likely that IPOs will remain largely out of bounds for PE firms exiting in the near future, which leaves trade sales and secondary buyouts to continue leading the way for PE firms to exit their holdings. In addition, as private equity firms continue to sit on large amounts of dry powder, it is likely that the demand for secondary buyouts will continue at current levels, leading to sustained levels of activity in the sector for the remainder of this year. In recent quarters Europe has experienced the greatest surge in secondary buyout activity, with 165 secondary buyout deals valued at $40.1bn in 2011 versus 150 secondary buyouts worth $17.9bn in North America during the same period. In 2012 to date, there has been $12.3bn and $14.7bn worth of secondary buyouts in Europe and the North America region respectively, with another $3bn in the Asia and Rest of World region. These high levels of secondary buyout activity in Europe could be a reflection of a difficult deal environment in the region, which has led to a dip in overall buyout activity in the region since H2 2011 and made secondary buyouts an extremely attractive option for both those PE firms that are looking to sell assets and those that are looking to buy assets. With conditions in Europe remaining tough, it is expected that the region will continue to lead the way in secondary buyouts for the rest of the year.
Goold: In short, I do expect to see continued secondary buyout activity this year. The dynamics described above mean that secondaries will be a common feature in the PE industry going forward. Whilst the lower mid-market remains relatively robust, however, the Eurocrisis is dampening risk appetite across the board and so the volume of transactions may well suffer in line with the M&A market generally. We shall see…
Richard J. Welch is a partner at Bingham McCutchen LLP. He is the co-chairman of Bingham’s Corporate Area and managing partner of the firm’s Los Angeles office. Mr Welch engages in general corporate law, focusing on mergers and acquisitions and the representation of private equity funds and growth companies. He has acted as the lead acquisition counsel in connection with more than 30 management buyouts and portfolio company dispositions in the $250m to $2bn range in a wide array of industries. Mr Welch serves as outside corporate and securities counsel to several public and private companies, and he has also represented both issuers and venture capital funds in numerous public and private financings. He can be contacted on +1 (213) 229 8510 or by email: rick.welch@bingham.com.
James Goold is a partner at Jones Day. He has been practicing corporate law for more than 15 years, advising on a broad range of matters across a variety of sectors with particular focus on private equity and M&A transactions. Mr Goold has extensive experience in the UK, the EU and international private equity sectors, including management buyouts/buyins, leveraged buyouts, and venture and development capital investments acting for institutional investors, management teams and investee companies. He also has extensive experience in all major types of corporate and corporate finance transactions, including domestic and cross-border M&A, initial public offerings, public fundraisings, and take-private transactions. He can be contacted on +44 (0)20 7039 5244 or by email: jegoold@jonesday.com.
Manuel Carvalho joined Preqin in 2007 and now heads up Preqin’s private equity deals research. Preqin covers global buyout and venture capital deal activity, with a database of over 50,000 deals detailing extensive information on these transactions, including deal value, buyers, sellers, debt financing providers, advisors, exit details and more. Prior to his current position, Mr Carvalho led the private equity fund manager data team at Preqin. He is a regular contributor of articles and features in the financial press, and his comments and research have featured in a range of leading financial and private equity-focused publications. He can be contacted on +44 (0)207 397 9460 or by email: mcarvalho@preqin.com.
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THE PANELLISTS
Richard J. Welch
Bingham McCutchen LLP
James Goold
Jones Day
Manuel Carvalho
Preqin