28 Oct 2015Secondary Buyouts: How They Create Value
Private Equity firms generally deploy a number of strategies to maximize the value creation of their investments. Profitability of any investment depends upon realization of a successful exit strategy. Traditionally, private equity firms resort to three exit options namely, a Corporate Acquisition, IPO and Secondary Buyouts. Earlier IPO’s or corporate acquisitions were considered as successful exits as these tend to maximize their returns, however, of lately secondary buyouts have gained importance as a preferred exit route.
What are Secondary Buyouts?
When a financial sponsor or private equity firm sells its investment in a company to another financial sponsor or private equity firm thereby terminating their involvement with the investee company, are known as Secondary Buyouts. Earlier these kind of transactions were perceived as “Rush Sales” as it was believed as the current investors are not able to generate returns, hence are disposing off the investment.
However, a recent surge in these buyouts have been registered mainly due to change in investor outlooks and due to influxion of large amounts of committed capital. Also, as these transactions provides instant liquidity to the investors as lump-sum amount is immediately paid opposed to the staggered compensation received in an IPO due to the lockup periods requirements, hence contributing towards their attractiveness.
INVESTOR’S PERSPECTIVE ON VALUE CREATION
Executing secondary buyouts make sense when the selling firm has already realized significant gains from the investment or when the buyout can still generate value, hence, the wealth generating potential results only from the value-adding services and the involvement of the new investor in the company. Below listed are some of the ways by which value-addition is accomplished:-
1. Operational Advancements: Private Equity firms possess varied kind of talents and expertise area utilizing which value addition could be done in the invest company. It is also known that secondary buyouts are majorly used during the expansion phase because different investors engage in different life cycle phases of a company, therefore the acquiring investor might be able to utilize his distinguished expertise in order to scale up the company and maximize its value.
2. Extending Geographical Reach: Some investors possess the capabilities of expanding the reachability of the products by entering into newer markets where they already possess the understanding of the nuances of that particular market. It is also known that finding local Joint Venture partners is a tough job where reach of the private equity players can certainly help. Therefore, a secondary buyout with the intention to expand into hard-to-access territories opens opportunities for growth which are not easily available to the company.
3. Reduction of Information Asymmetries: As the information in the business environment is distributed unevenly, hence various gaps could arise at the time of strategy execution. Also, as PE investor develop strong experience in concerned industries, hence they are better able to reduce information asymmetries.
4. Reduction of Overinvestment problem: As entrepreneurs utilizes investor’s money in his venture, there is a possibility that the entrepreneur continue to invest in a project with negative NPV, which has the lower probability of turning successful. This problem could be addressed when further financing comes from new investor after the buyout, whereby the new investor could commit only a certain fraction of the capital needed and subsequent rounds could be done on achievement of laid-out milestones.
5. Economies of Scope and Learning Curve Effects: As private equity players invests across different ventures, they are able to create a referral network which could be utilized efficiently as they have the advantage of cross-selling the products to their existing portfolio companies. PE’s also benefit from learning curve effects as learnings gathered while implementing strategies in one company reduces their informational costs for subsequent times.
Hence, it is deduced that a private equity investor acquiring a portfolio company in a secondary buyout might be able to pay a higher price thereby increasing the returns for the retiring investors. However, due diligence should be conducted at the part of new investor whereby he should assess the impact his investment/presence could make to the investee company and should ensure that the full potential of their subject company has not yet been realised because it might be a case where existing investors are utilizing secondary buyouts as a means for capital recycling where only wealth re-distribution effects are utilized to increase exit value and no real value is being added.