Secondary buyouts: black sheep of the industry?

John Bakie
19 November 2010

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Secondary buyouts have often come under fire, accused of offering poor returns for LPs. But new research suggests secondary returns can match those seen in primary buyouts. John Bakie investigates

The practice of buying portfolio companies from other financial owners has often been criticised for representing a bad deal for the fund's investors. Many argue that, by acquiring a firm from another private equity house, there is little chance of making a substantial return, as value-enhancing measures will have already been exhausted by the previous investor.

Though secondary buyouts had been considered an undesirable route for both buyers and sellers, intense criticism really began when the financial crisis first hit in late 2007. As economic conditions deteriorated, so too did the appetite of many trade buyers and public market investors, and more private equity funds sought to sell their portfolio companies to their peers. The increase in secondary buyouts raised significant questions over how profitable they could be.

However, research from Munich-based fund-of-funds Golding Capital Partners suggests secondary purchases have, on average, nearly the same value-creating potential as primary buyouts. The fund-of-funds manager used data on portfolio companies, gathered as part of its due diligence process, to analyse the returns produced by secondary buyouts. It found the median IRR for a secondary buyout is 31.9%, compared to 37.9% for primary transactions. Returns achieved were more likely to be affected by other factors, such as timing, deal size and region, rather than whether or not they were secondary transactions, according to Golding.

"In the past there was always a question mark about the attractiveness of secondary buyouts," says Jeremy Golding, managing director of Golding Capital Partners. "This study provides empirical proof that for private equity funds, secondary transactions are just as primary buyouts. Fundamental opposition to buying companies from private equity funds is clearly not justified."

The secondary buyouts studied by Golding not only produced reasonable returns for investors, but were also beneficial for the portfolio companies. Operational value creation showed little difference between primary and secondary deals, with similar increases to both EBITDA and free cash flow. Similarly, firms did not require an increased use of leverage to boost returns. Secondary buyouts do use slightly more leverage on average than primary deals, but the difference (1.9:1 for primaries compared to 2.1:1 for secondaries) is insignificant, according to Golding.

The debate over whether secondary buyouts offer a good deal for LPs will, no doubt, rage on, and in some cases LPs' concerns will be quite justifiable. However, Golding's research suggests that much of the criticism levelled at secondary buyouts as a whole may be unwarranted.