“Pass-the-parcel” deals – spotting the good and the bad

Secondary buyouts, the sales of businesses by one private equity firm to another, have been much written about of late. That’s not surprising; they have accounted for more than half of European private equity deals this year, according to data provider Preqin.

A good deal of the commentary surrounding them is sceptical. ‘Pass-the-parcel’ is a phrase often used, while others describe a deal ‘merry-go-round’. Neither term is meant to be flattering.

In reality, secondary transactions very often make good economic sense and to describe them uniformly misses the subtleties of each individual deal.

In the case of a sale by one firm to another of similar size and skill-set – one mid-market UK fund, say, selling to another – some concern is justified. In those circumstances an LP invested in the acquiring fund may ask where the value-add will come from: an LP invested in both funds even more so.

But firms and their funds vary hugely in size and experience. An acquiring fund may well bring capital for investment or operational experience that the incumbent can’t offer. Equally, a fund with a broader geographic footprint will have networks and relationships that can be used as the portfolio company expands from its domestic market. We regularly see the value in a growing private equity-backed UK business taking investment from, say, a more Europe-focused fund.

It’s simplistic, too, to assume a business, having been once private equity backed, has no further scope for improvement and growth. Longer holding periods mean market shifts may have presented new challenges and so opportunities for incoming ‘secondary’ backers. In such circumstances we see secondary transactions - where there are clear improvements and efficiencies to be made - show more of the assumed characteristics of a primary deal.

Even in circumstances where the same private equity house buys back into an asset it has previously held (a number of recent examples described here), there may be a sound investment thesis behind the deal. A firm will buy back into a previous portfolio company – typically one it has been apart from for a number of years – only if it can see a route to further value creation. Companies grow and change and the market opportunity for that company can shift. Likewise, a private equity firm can change: growing either its operational know-how or financial clout.

Secondary buyouts should be judged on their performance, but the existing body of research presents a mixed picture. Some studies show secondary buyouts to have performed at least as well as their primary equivalents. They are also shown to do so with less variability in returns, a function of secondary acquirers knowing better which businesses operate well under private equity ownership.

Other research is less favourable. An in-depth study published at the end of 2013 (view here) found that secondary deals “generate much lower average returns for buyers than comparable”. The study separated deals between those made early and those made late in the fund’s investment period. The later investments - with GPs eager to invest money ahead of a looming cut-off point - were typically made at higher prices and performed poorly. Those made early in the fund life were secured for ‘fairer’ prices and provided returns as a good as the primary deals considered.

Ultimately, as that report shows, there are good secondary deals and bad ones; the same could be said of primary transactions. We should be cautious of lumping either into vague categories. If you would like to discuss this further then please contact me using the details below.

Duncan Skailes | Partner
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