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Developments in secondary buy-outs

Secondary buy-outs are currently enjoying rapid growth in the UK as alternative exit routes remain closed. The Centre for Management Buy-out Research reveals in the key findings of a recent survey that although private equity firms prefer more traditional routes, such as IPO or trade sale, secondary buy-outs are the next best thing.

Key findings of in-depth interviews with sixteen private equity investors concerning developments in secondary buy-outs.

• The peak number of secondary buy-outs to date was the 45 recorded in 1998. After falling in 2000, the number of secondary buy-outs increased last year to 36.

• Secondary buy-outs reached a record 27.3 per cent of non-receivership buy-out exits in 2001.

• Private equity firms saw greater pressure to develop an exit-focused strategy from the beginning. This leads to increased pressure to seek alternative exit routes and regular dialogue with senior management to discuss exit opportunities.  

• The slight majority of investors (nine out of sixteen) who were not in favour of secondary buy-outs as an exit of choice reasoned that they did not generally provide the maximum value return for their investments, unlike a trade sale.

• The almost half of respondents who had a positive attitude towards secondary buy-outs as an exit reported that in current market conditions, financial investors with large amounts of funds at their disposal have become major effective buyers and may offer a greater price than trade buyers.

• A major positive incentive for investing in secondary buy-outs is the visible track record of the incumbent management and its experiences in working with venture capitalists.

• There was caution in terms of the need to be clear about management's continuing commitment and motivation; the danger in taking a rosy view if the incumbent management stays with the business such that faults are overlooked; the need for future business prospects to be clear; and the need for incoming investors to be sure they can add value in a way that the original investor could not.

• Most private equity investors interviewed estimated that secondary buy-outs accounted for 10-15 per cent of their deals in the previous year.

• Some investors considered that previous involvement by a private equity investor gave them added confidence regarding the quality of the information provided at the due diligence stage. For others there remained some distrust in negotiating with fellow private equity investors, but this problem is diminishing over time.

• All investors recognised that secondary buy-outs were important in sustaining deal generation in the market currently and that their credibility would increase as this sector of the market matures but would make the market even more competitive.

• All but two of the investors interviewed suggested that in most instances the management team wanted a bigger share of a bigger business. A balance needed to be struck between realising some of management's gain and committing sufficient funds to the next deal.

• Only three respondents stated that they would expect to give management a larger equity stake in a secondary buy-out.

• Seven of the respondents were prepared to take minority holdings in the secondary buy-out but would use restrictive covenants or preference shares to enable them to take control. Of the remaining investors, most would allow management to hold up to 49 per cent of the equity, but three investors were sensitive to management having more than around 25 per cent.  

• Only one respondent considered that a secondary buy-out was likely to have a higher leverage ratio than a primary deal, although others considered that debt levels could be higher as deals are generally larger.

• Almost all respondents considered secondary buy-outs to carry the same or lower risk than primary buy-outs. The lack of warranties with secondary buy-outs was mentioned by all investors as a cause for concern.

• All but two of the private equity investors were clear that the investment strategy for a secondary buy-out must be different if the deal is to succeed as any efficiency benefits should have been implemented during the first buy-out.

• The majority of investors suggesting a change to the strategy for a secondary buy-out recommended growth through a buy and build programme but two appeared to be more open to alternative growth strategies.

• The revised investment strategy is likely to be focused towards making the business more attractive to exit. A buy and build strategy may be aimed at making the company more attractive to either a trade buyer or making it large enough to consider a flotation.

• The life-cycle for a secondary buy-out was estimated by all respondents to be either equal to or shorter than that for a first buy-out, with expectations being in the range of 3-5 years.

• Management continuity contributes to a shorter investment life for a secondary buy-out as it brings expertise and greater market knowledge and enables private equity firms to utilise their time more effectively on planning an exit.

• Trade sales were seen as the likely exit route for secondary buy-outs, particularly if the firm had pursued a buy and build strategy or shown significant growth. Only two private equity players were thinking in terms of a further buy-out as an exit route, mainly in smaller businesses and where it offered the opportunity for management to lever up its stake in the business.

Copyright © 2002 CMBOR

The Centre for Management Buy-out Research is sponsored by Barclays Private Equity and Deloitte & Touche at the Nottingham University Business School. The Centre for Management Buy-out Research (CMBOR) was founded by Barclays Private Equity Limited and Deloitte & Touche at Nottingham University Business School in March 1986 to monitor and analyse management buy-outs in a comprehensive and objective way. As an independent body, CMBOR has developed a wide-ranging and detailed database of over 17,000 companies, which provides the only complete set of statistics on management buy-outs and buy-ins in Europe. CMBOR publishes regular reports on buy-out trends and relevant issues in its UK Quarterly Review and annual European Management Buy-out Review. Centre for Management Buy-out Research (CMBOR), Nottingham University Business School, Jubilee Campus, Wollaton Road, Nottingham, NG8 1BB, 44 115 951, Andrew.Burrows@nottingham.ac.uk, www.cmbor.org