UK: Secondary Buyouts - Rewriting the Rules

Secondary buyouts are on a bit of a roll. These sales between private equity houses continue to be a valuable deal source and attractive exit routes for investors. Latest figures show that the total value of secondary buyouts increased again in 2005, accounting for over £8.5 billion.

With vast amounts of private equity money still being raised and fund mangers focused on achieving timely exits, the growth in secondary buyouts seems set to continue for the foreseeable future. At the same time the market is becoming more and more competitive with auctions now driving many mid-market secondary buyouts.

So what factors must investors consider when embarking on a secondary buyout?

Risk factors

Investors need to be alive to the differing risk profile of a secondary buyout where warranty coverage can be far more limited than that traditionally offered on a sale of a business. Market practice has dictated that, with very limited exceptions, private equity houses will not give warranties on a sale. Whilst this can be unpalatable for trade buyers, private equity houses (no doubt with an eye on any impending exits in their own portfolio) are more accepting of this position. This leaves investors having to rely on warranties and a tax covenant provided by the incumbent management. As a rule of thumb, management's overall cap on liability is usually linked to a proportion of their cash out (anywhere from 30%-70% of cash actually received). Taken together with the fact that part of management's price will be rolled over, this is clearly some way off the traditional benchmark of giving warranties with a cap on liability set at the purchase price.

To heighten the stakes further in competitive auction processes the developing market practice is for management to resist giving a tax deed. Instead the incoming investor has to satisfy itself of the tax position through thorough financial due diligence and price the deal accordingly. On paper this seems very robust but in practice it is being accepted.

That said, any risk factors must be considered in context. By the time the incoming investor takes control the business will have been through a thorough due diligence process – twice. A business in private equity ownership usually has more sophisticated systems of internal checks and reporting than, say, family-owned businesses. In addition, if management are rolling over it is unlikely they will keep matters concealed from the future business owner (and their new employer) if that future owner is, at least in part, themselves.

A secondary buyout will often provide a clean break for the selling private equity house. However, the management shareholders often remain integral to the ongoing business and frequently want to realise some cash out. This can present a dilemma for the incoming investor. On one hand it is critical to ensure that the managers' motivation remains strong and that they remain economically dependent on, and so motivated by, the eventual secondary exit. On the other hand, the investor needs to be competitive with its terms.

Managers will be expected to demonstrate ongoing commitment by making a substantial reinvestment in the future of the business. The purchasing private equity house will often seek to defer the managers' proceeds from the original buyout by loading as much of the consideration as possible into loan notes. These ideally only become repayable on the secondary exit. That said, more recently managements have found themselves in a stronger negotiating position on their reinvestment terms - largely due to the increased competition in the private equity market for secondary buyouts. In practice, a balance must be struck on a deal-by-deal basis.

Closely related to the cash-versus-reinvestment question is to what extent, if any, management will be able to retain their shares in the business or alternatively receive a minimum value for their shares and loan note reinvestment should they leave. On a first-time investment, a departing manager will usually have to sell his shares if he exits the business and, in most circumstances, will not receive market value for them. This approach may change on a secondary buyout, where managers may point to a significant accrued value in their reinvestment. If a manager is under pressure to increase his rollover he has a much stronger argument that he should retain his investment in the business even if he parts company from it prematurely. In practice this issue is often dealt with by creating two classes of managers' shares – one crystallising the managers' historic value, and another which represents the future. This can give the investor the flexibility to negotiate a position which recognises the work each manager has done to date but allows for future succession planning.

A growing trend

Despite their issues, the popularity of secondary buyouts seen in 2005 looks set to continue in 2006 as more investee businesses start exit planning. It will be interesting this popularity continues to challenge the "traditional" sale model and whether the market will continue to adapt, ultimately impacting on the way we all do deals.