Previously regarded with deep-set scepticism, the rate of secondary buyouts has risen sharply in 2004.

In industry parlance, a secondary buy-out is known as ‘a buy-out of a buy-out’. These deals are when one private equity firm sells a business to a rival firm or other financial backer. Prior to this year, they were regarded with deep-set scepticism, surrounded by stigma and even termed, by the cynics, the ‘exit of last resort’. There also weren’t very many of them. However, something radical has happened in 2004, as secondary buy-outs have so far accounted for half of the top 35 buy-out deals completed.

It’s where the action is
Their growing popularity is being fuelled by two factors. Firstly, a growing number of mature businesses are seeking alternative ways of funding growth that don’t involve a stock market flotation. Secondly, according to Tom Lamb, managing director UK at Barclays Private Equity, ‘a number of private equity firms will be walking the fundraising trail next year’. They therefore have a need to liquidate existing investments to give them sufficient financial resources for new ones.

Barclays has thus far completed four secondary buyouts this year, and Lamb expects the number to keep increasing. ‘Private equity houses have become more confident in the roles of buyers and sellers to each other. Ten years ago, there was a deep suspicion in deals going from one private equity house to another. But a lot of venture capitalists are seeking to raise new funds – and need to have exits – and trade buyers are becoming more discerning,’ explains Lamb.

Andrew Burrows, director of the Centre for Management Buyout Research (CMBOR), which monitors and analyses the buy-out sector, believes that secondary buy-outs are important, not just in terms of number, but also in terms of value.

‘The total value of secondary buy-outs this year has been £4.8 billion. It’s an area where all the good deals are currently being secured,’ he comments.

Conflict resolution
The CMBOR says that secondary buyouts are a useful means of resolving different objectives of shareholders. For example, the management of one business may wish to continue as shareholders for a longer period than the original private equity backers. Secondary buyouts can solve this conflict.

Often though, a secondary buyout will be sparked by the original venture capitalist and the original management buy-out team seeking an exit, and a second tier of management looking for a slice of the action.

‘It’s fairly rare that you see the same person or group of people who carried out the first buyout all participating in the second one. A secondary buyout is an option for a business that needs further cash for growth but doesn’t want to float, or sell out to a trade buyer at a discount to real worth,’ comments Judith McMath, regional managing director of asset-based lender Enterprise Finance Europe (EFE), which recently funded the secondary buy-out of demolition and waste management company Webfell Group.

Show me the money
Certain conflicts can arise, though, over how much the new or remaining management is willing to reinvest in the business second time round.

‘A secondary buyout can give some managers an exit route, as well as enabling others to continue leading the business. Therefore you can be faced with a situation where the managers are both the buyers and the sellers. With secondary buy-outs, the businesses are more highly geared and therefore come with increased risks. There is also the rollover issue to consider – how much are remaining management required to leave on the table?’ asks Mark Spinner, head of private equity at solicitors Eversheds.

As Spinner elaborates, many private equity players will expect management to roll over their wealth into the deal going forward.

‘At the end of the day, you want an alignment of interests. Money isn’t going to be the only incentive, and what is life-changing for one person is not going to be the same for others,’ comments Spinner.

Insurance is key
A secondary buyout deal is carried out much along the same lines as those of a primary one. But besides the possible conflicts of interests as mentioned above, other complexities, involving negotiations of warranties, may emerge.

If the private equity investor is selling, it may refuse to give warranties or indemnities, as for the most part it acts as a fund manager and is therefore obliged to distribute any proceeds from exits to those who have invested in the funds. To ensure that the buyer receives some warranties, the burden often falls on the management team to give sufficient warranties to back up the price.

‘The private equity house that is exiting will want to walk away without any warranties or indemnities and the purchasing private equity house will want as much as possible. In the case where a company is 70-80 per cent owned by private equity, the management will be left on the hook for pretty much everything,’ believes Spinner.

However, there are ways to soften the blow. As Spinner adds, some institutions have been willing to give certain warranties to get a deal away and to help cover the management’s risk. Other solutions include warranties backed by warranty and indemnity insurance.

It can, in some respects, also be easier to pull off a secondary buy-out, because the management will be used to living with a financial backer, will know the rules of the game and certain controls will already be put in place.
‘Having been owned once before by a financial owner, the company will be much more organised and the new owner can take some comfort from that,’ comments Jim Keeling, of Corbett Keeling, which helps companies raise equity finance.

Don’t rush in
According to Hugh Lenon, managing partner of Phoenix Private Equity, which has completed two secondary buyouts this year, some deals can be done in as little as five weeks, but the average time is usually two months.

However, EFE’s McMath believes that secondary buyouts are not the type of deals you want to rush into.

‘It’s far from being a simple sale. There are many different emotions to consider: the venture capitalist will want as large a return on the money they invested, the management team will slightly depress the price so they don’t have to take on so much debt/finance and then you have to consider the new buyer’s interests. Everyone wants a win-win situation,’ she explains.

No low-hanging fruit
‘An important part of the deal structure for us is to make sure the management have skin in the game,’ says Lenon. ‘We ask ourselves whether the business can still grow, whether the management team are still incentivised, and what we can do that’s not already been done by the previous investor.

A key challenge if existing management are exiting the business is to ensure that the next layer of management feel they are getting as good a deal as the previous ones.’

This view is echoed by Lamb. ‘When a company goes through a primary, management buy-out situation, 50 per cent is added to the efforts of people who get an equity stake. The sales growth is better and capital expenditure is better directed. With a secondary buy-out, you don’t get that effect – the easy gains and low-hanging fruit are at the primary buyout stage.’