Direct secondaries: breathing new life

The continued rise of secondaries since the first record year in 2010 is testament to LPs' increasing demand for liquidity: secondaries deals totalled $25bn last year, double the 2009 value and 10x the 2002 level.

But this is at fund level; LPs' willingness to engage on a deal-by-deal basis has been slower to materialise. "LPs need to form a view on whether they want their money to stay stuck in old deals simply because change is too hard, or if the LP community as a whole wants to do something about this legacy asset build-up," warns Julian Mash, CEO at Vision Capital, a direct secondaries player set up in 1997. "It's easy to do nothing. It's easy to say ‘It's too difficult to change'. But that's sub-optimal."

The idea of private equity zombies is not new, but the speed of their proliferation is. The number of ‘zombies' in the UK is at a four-year high, with one in seven businesses (or 432,000) only generating enough cash to pay off interest, according to Begbies Traynor, an insolvency practice. And private equity-owned businesses are among them: the NAV of ageing private equity assets is set to grow nearly five-fold between now and 2016, exceeding $50bn globally, according to Vision.

While the US is expected to remain the main area of opportunity for investors, Europe's share of ageing assets is set to grow the most during the time period, with a 15x increase forecast, to roughly $9bn by 2016.

As time goes by, the GP of a zombie fund becomes increasingly focused on maximising, or at least preserving, its investment - which can conflict with management's vision of growing the business. "The longer an investment goes on, the less a management team can grow the business and that's frustrating for everybody," says Mash. "If you're in a fund too long, it can run out of money and so even if you spot an attractive acquisition target, there isn't the money to do it."

Vision is au fait with this, having completed the purchase of three tail investments from US GP Willis Stein last year. The 2000 vintage fund was under pressure from some of its LPs to wind down, but Vision and Landmark Partners managed to work with select members of the incumbent GP to purchase the three businesses. The LPs were thus offered a way out, while the remnant three companies were able to be reinvigorated via new owners and - crucially - fresh capital to ensure growth was possible. The deal saw a number of investors in the fund remain.

Maintaining motivation

Keeping GPs in check is often considered by investors, with aforementioned secondaries a way to salvage some investment and fund resets increasingly commonplace. "Many investors recognise that GPs may divert their focus to more promising successor funds rather than work hard on an underperforming portfolio in the absence of new performance-related incentives," says Sonya Pauls, partner at King & Wood Mallesons SJ Berwin. "In addition to resets, we are seeing an increasing number of LPs who are seeking to reinvigorate zombie funds by resetting the waterfall. Often, such arrangements include dropping or lowering the hurdle or readjusting the waterfall to a limited deal-by-deal model. It is important for investors to pragmatically focus on future potential rather than to seek sanctioning the past."

Less talked about is how to keep the management teams of private equity-backed businesses enthusiastic even when their own equity is under water. "Most importantly, you need alignment of interests and expectations," says Simon Tilley at DC Advisory. "Ideally, both the private equity backer and management team of the portfolio company go in with the same expectations and keep communications open. Relationships can break down if misalignment occurs or communication flow is inadequate.

"Extended hold periods aren't always a problem because - at least from a private equity perspective - people are more interested in multiples than IRRs, especially if the fund is in carry. But if you've got some proactivity in planning for exit, then management is more aligned, too."

Of course, private equity has always been about this, with motivation of management of fundamental importance to GPs. But this can become tricky when capital structures go awry and you can end up with companies and management teams that get hamstrung, with no visible end in sight.

Electra Partners stepped into such a company last year when it acquired the debt of Park Resorts from Lloyds for a discounted £45.5m. The company's private equity roots stem from 2001 and, in 2007, GI Partners bought it in a £440m secondary buyout from ABN Amro and Close Brothers. Earlier this year Electra Partners refinanced the company, appointed a new CEO and took an equity stake of 54%.

"When we arrived in 2012, we had a team and a company that couldn't really make progress under the existing capital structure, as there were limited rewards for success," says Alex Fortescue, chief investment partner at Electra Partners LLP. "We adjusted the structure to give the business the headroom and capacity to start investing again. And we devised a management equity scheme to revise the current situation to ensure the management team could be rewarded if they did very well."

And Electra Partners recently acquired South Lakeland Parks (SLP) for £47m with debt from Investec Growth and Acquisition Finance. The acquisition was made in partnership with Park Resorts, which will manage South Lakeland's parks under a management contract. As Fortescue explains: "SLP has a very similar set of issues [to Park Resorts]." It was a £100m buyout in 2006 led by LGV Capital and just over a year later was sold for £125m to White Ocean Leisure. This deal generated a handy 72% IRR for LGV, but was less fruitful for SLP: it had been overleveraged in the 2007 deal and ultimately the lenders, Irish Bank Resolution Corporation, took over the business. Electra Partners purchased the business outright from Irish Bank and is now using Park Resorts' management team to manage the business and put in a sweet equity scheme for the rest of management.

Vision's direct secondaries require a huge effort in reinvigorating management teams that may have grown weary of private equity. Says Mash: "It all starts with a forward-looking medium view. What is the outlook for a business over a medium-term horizon? And what does it need to get there? Does it need capital, expertise? We buy portfolios, but look at the management of each company and this means we sometimes look at remotivation and team changes."

Once the team is in place, it is about enthusing them. "You have to start with what is your sense of the potential of the business and how can you work with the team to get there. Financial incentives obviously play a role, but it is not enough. It's about helping people realise their vision, because everyone has an inherent instinct to achieve their potential."

The exercise not only serves to restart the clock on a private equity-backed business, but can often refresh the GP by removing a handful of ‘"problem children" from their portfolio.

Timing is everything

Time constraints are inherent in limited partnerships, though quick flips in the run up to the crisis meant patience was rarely tested. According to unquote" data, investments realised in 2006 had been held for an average of 3.9 years; this rose to 5.8 years for deals exited last year. And there are signs this will grow further: 44% of all European buyouts completed in 2006 are still in private equity hands, and 57% of investments done in 2007 are yet to be realised. The latest value study by EY suggests the current portfolio of European private equity assets (acquired since 2005 and with an EV at entry of €150m or more) will take, on average, 11 years to exit.

This will have implications for limited partners, who had signed up to five-year exit periods in the LPAs they agreed to.

"This has an extraordinary impact on investors," says Mash. "Tying up their capital like that means the entire cycle of investment allocation decision making is constrained."

Not all GPs are pressured by limited partners and the ensuing timeframe that such funds entail. Electra Private Equity, one of the oldest investment trusts in Britain, is a case in point.

"Having the plc account for the majority of capital is a tremendous benefit to thinking of hold periods or backing businesses with more capital after the initial investment," says Alex Cooper-Evans, investment partner and head of investor relations at Electra Partners. "We have permanent capital versus a time-limited limited partnership - so we can hold assets as long as we like." Indeed, Electra Partners shortest hold period was just 21 days, while its longest was 24 years.

A 15-year hold period saw Electra reap 15x money and an IRR of 28% when it sold Allflex to BC Partners in July. The total gross proceeds for Electra Partners and its clients reached $631m, with $836m returned to investors overall, including refinancings.

Electra Partners first backed the firm in 1998, contributing $46m to the $160m secondary buyout of the company. The asset was acquired from Goldman Sachs Private Equity New York with mezzanine provided by Intermediate Capital Group and the Royal Bank of Scotland. The company was refinanced in 2003, 2005 and 2007.

The GP still holds a torch - Electra Partners reinvested in the business for a 15% stake a few months after the July sale. "Our structure is why we've been able to reinvest in Allflex," says Cooper-Evans. "This would have been difficult with traditional limited partnership funds as it would be one set of investors cashing out and another going in."

And how did Electra keep the romance alive for the team at Allflex? "The business was growing and, as the management team were shareholders, they could see they were generating value for themselves," Cooper-Evans explains. Electra Partners also led three refinancings for the business in the run-up to the sale. "This highlighted for management that the asset value was growing since it generated distributions for them." Tilley believes refinancings can be a useful way to keep management teams motivated. "Doing a recap to make the capital structure more efficient ahead of an exit can help management take money off the table and replace some expensive private equity loan stock, in favour of cheaper debt. This helps management's relationship with private equity - assuming there is an exit in the next 12-18 months."

Indeed, Graphite refinanced global recruitment specialist NES prior to its sale in October 2012. The six-year hold (following NES's seven years with Bridgepoint) saw Graphite reap 4.7x money shortly after the GP put in place a banking club to facilitate a new buyer.

In fact, unquote" is recording an increasing number of refinancings, with many of these targets then up for sale, highlighting Tilley's sentiment. But more can probably be done as the issue of ageing assets - and so under-motivated GPs and management teams - grows. Says Mash: "There should be an industry way forward on this. I'd never advocate anything other than clarity and transparency."

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