LPs getting to grips with the (right) secondary buyout

The growing proportion of European buyouts sourced from another private equity house – from a quarter between 2000 and 2010 to more than a third last year in volume terms – highlights the elusive nature of primary transactions in the post-crisis environment. This is even more obvious at the top end of the market, where primary opportunities became statistically more difficult to find as the industry matured and sizable financing packages progressively dried up for all but the safest of deals: of the top five buyouts completed in 2012 so far, four were sourced from a fellow GP.

Luckily for fund managers, it would seem that LPs have somewhat softened their stance on "pass-the-parcel" deals in light of the odds stacked against primary transactions. Christophe Bavière, CEO and managing partner of fund-of-funds manager Idinvest Partners, favours a pragmatic approach as far as secondary deals are concerned: "What really matters is the quality of the deal itself. Some secondary deals make absolute sense and present a very good risk/return profile, while some primary transactions should be avoided, notably in very cyclical sectors."

Christiian Marriott, a partner in charge of investor relations at Equistone, agrees that the safety factor definitely makes SBOs an easier sell to investors: "Some LPs seem to attribute different risk/return profiles to primaries and SBOs. They might not expect a 5-10x return on a secondary deal, but equally they have a reasonable expectation that you know what you are buying and that the company and management should be in fairly good shape."

SBOs come with much less of a potent stigma nowadays – but strong primary deals are still likely to woo LPs

Furthermore, GPs are keen to point out that equating primaries with higher returns is not that simple. "In the last six years we have made a double-digit return three times: twice on primary transactions and once on an SBO," says Marriott. "I think it would be tough to demonstrate empirically that one could attribute radically different risk/return profiles to both transaction types – there are just so many exogenous factors in the success of a deal, over and above who owned it before."

This is further compounded by the fact that, given their scarcity, good primary deals aren't necessarily a bargain, argues Grant Thornton partner David Ascott: "It is very hard to find overlooked and unloved assets out there: a high level of competition means that very good primaries still go for high prices."

The argument of secondary transactions being a by-product of a mature industry is also not lost on LPs, Marriott adds: "LPs are quite accepting of the fact that if you invest in a fund, it will sooner or later buy a business from another GP. There is a stock of privately-held companies that are available for PE houses to buy: some are going to be owned by families or corporates, but the maturity of the European PE industry means that some of those companies will inevitably be owned by PE funds."

That said, not all SBOs seem to be able to pass muster with picky investors. The main issue many of them used to have with endless secondary deals was the lack of diversification, whereby the assets would eventually be going back and forth between funds already in their portfolios. This remains on LPs' minds today. "When we are announcing an exit, a lot of our LPs clearly want to know whether we're selling to one of their other portfolio funds or not," says Marriott, before adding that selling to a fellow GP is not necessarily a black mark. "LPs are much more comfortable seeing a company passing between firms that are at different points in the food chain, rather than direct competitors. Even if the IRR and multiples were exactly the same, many LPs would be happier seeing one of our portfolio companies being sold to a large buyout fund as opposed to another mid-market player or a country fund."

The Foundry can be seen as a case in point. Advent Venture Partners bought a majority stake in the UK-based company, then a simple plug-in developer, in 2009. Two years later, the business had become a visual effects software provider, with its products being used on films such as TRON: Legacy, Alice in Wonderland and The King's Speech. Few of Advent Venture's LPs must have bemoaned the choice of exit route when the business was sold to heavy-hitter Carlyle, reputedly allowing the seller to reap a triple-digit IRR.

On the other hand, Bavière warns that "copy/paste" deals won't be getting much love from LPs: "Investors are certainly not keen on the situation where a business is on its fifth LBO and all the GPs seem to have the same angle, the same lenders, and where the management is so familiar with private equity ownership that the hands-on approach is minimal. This is however more common at the top-end of the market, and less of an issue with mid-cap transactions."

Still the poster child
So it would seem GPs and LPs alike have come to terms with SBOs, as long as they are not a blatant exercise in lazy origination and if there are sufficient avenues for further value creation. Then why are GPs still so proud to highlight their primary deal-making prowess? "What remains true is that LPs are naturally looking for managers able to source deals by themselves and have a hands-on impact on a business's operation," says Bavière. "A GP in fundraising mode trying to showcase its best investments to an LP will tend to focus on primary, proprietary deals in which he paid an attractive price and was able to really drive value. He will unsurprisingly be less proud of a quaternary buyout with a higher entry multiple and where he took on an already efficient business, even though the IRR and risk/return profile were ultimately very good for his investors."

There undeniably appears to be a strong marketing element still associated with sourcing primary transactions, especially at a time when many managers are facing stiff competition on the fundraising trail. It certainly worked for Chequers Capital: the French mid-cap GP retained more than 80% of its LP base when it closed its €850m vehicle in a speedy four months last year. Asked to explain this success, it was proud to mention that 12 out of the 14 buyouts its previous fund completed were primary transactions.

"It can be difficult today to establish how the myriad mid-market buyout funds that emerged in the early 2000s differentiate themselves from one another," Bavière explains. "One of the best ways to do so is to see those GPs work alongside the managers of their portfolio companies on a day-to-day basis. We are really looking for this rare chemistry between a PE house and a management team – this undeniably happens more often in primary transactions, or on those few SBOs that really stand out from the crowd."

This article is an extract from a more in-depth look at the primary market, featured in the latest issue of the unquote" analysis magazine.

• Tweet  
• Facebook  
• LinkedIn  
• Google plus  
• Send to  

• Topics
• Buyouts
• LPs
• Secondary buyout
• Top story