The secondary buyout "selfie"

Holding periods for portfolio companies have been stretched since the global financial crisis. Traditional exit routes have frequently been blocked or scuppered by market conditions resulting in an "exit overhang".

In better times, a 2005 vintage fund would have already returned its LPs' invested capital plus – at least – a portion of the money multiple expected from the vehicle. The current reality is that around two-thirds of 2005 vintage funds have yet to return even their investors' paid-in capital to date.

This exit backlog is perhaps most evident in central-eastern and southern Europe. Despite the public markets showing some small signs of life – the Warsaw Stock Exchange had a strong Q3 in terms of IPO volumes and the Bucharest Stock Exchange can also boast some recent success stories – private equity exits via IPO remain at less than a third of their pre-2008 levels.

Against this backdrop, with LPs increasingly anxious for and demanding returned capital, GPs are looking at other options. Dividend recapitalisations have proved a popular option, provided the portfolio company is in strong enough shape and of sufficient size. Other options we have seen include "quasi-sell-downs", in which financial sponsors sell down a portion of their equity to another investor and retain a significant stake in anticipation of future upside but, with the ability to return at least some capital now. Elsewhere we have seen funds partake in "portfolio pruning" – hiving off non-core assets from portfolio companies to produce liquidity events – or call on the services of a direct secondaries investor. We have also seen stakes in family-owned businesses sold back to the family owners, instead of trying to run more traditional sales processes.

By far the most interesting method over the last 12 months, however, was the recent case of a GP selling a portfolio company from one early vintage fund to a later vintage successor fund. In other words, the financial sponsor transferred ownership of an asset – in this instance a perfectly healthy growing business – from Fund II, which is nearing the end of its fund life, to Fund III, which was just starting its investment period.

The process of selling a portfolio company to oneself seems at first fraught with conflicts. For example, how do you ensure fair valuation of an asset in what is the ultimate off-market transaction? How do you defend against allegations that one LP base is being enriched at the expense of another? Similarly, other stakeholder groups, such as lawmakers, employees and customers of the portfolio company, may see the situation – a business being sold and bought by the same financial backer – as suspect.

The winner takes it all
However, this type of transaction can be a win-win if executed in a proper fashion. The recent instance is an exemplary case in point. The two funds involved had different limited partner bases, so the valuation agreed on had to be unimpeachable. In this case the valuation allowed the earlier fund to exit and achieve a respectable return – more than 2x – while allowing the later fund to invest at a valuation at which it believed it could generate further gains.

And to be clear: this was an established private equity firm with a diverse LP base and substantial assets under management, not a small fund with one private backer.

In many ways, this is one of the few types of transaction where the potential investor can diligence the asset with near-perfect visibility, having been inside with the company for a number of years already. Any potential conflicts should – to a large extent – be self-regulating, as a GP will be unlikely to sell itself a "dog".

Nevertheless, there are still conflicts to be managed; it's conceivable that a GP could shift a poor-performing asset from one fund to another at an inflated or deflated price to receive a carry payment from one fund in exchange for a write-down in the other. Because of these risks, it is essential that the LP/investor advisory boards of both funds are heavily involved in and agree to the process, as they certainly were in this instance.

This type of exit – let's call it a secondary buyout "selfie" – is only ever likely to be used in a small minority of cases, but it can at least be counted as another weapon in the armoury of GPs that are looking to return cash to their LPs in a less than hospitable climate.

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