Private Equity Lemons?Evidence on Value Creation in Secondary Buyouts

• Published date: 01 March 2014

1.

Since Akerlof's () seminal paper on the impact of asymmetric information on the market for used cars, the term lemon has been associated with a defective used car. This paper addresses the question of whether the private equity market has its very own lemon problem. ‘Used’ private equity deals, commonly known as secondary buyouts (SBOs), denote the situation where both the buyer and seller are financial sponsors. Data on the evolution of the worldwide private equity market from Kaplan and Strömberg () show that SBOs have grown from 2% of total enterprise value (EV) in the first boom phase of private equity (1985 to 1989) to 25% by the second boom phase (2005 to mid‐2007).

This trend toward SBOs has been met with a certain amount of skepticism in the practical and research communities (Bonini, ; Sousa, ; Wang, ) for three reasons. First, the operational value creation potential in SBOs is thought to be limited, since the first private equity sponsor will already have realised all the ‘low‐hanging fruit,’ that is, the easily realised value creation measures with the largest impact. According to Cumming and MacIntosh (), a private equity investor will only sell a portfolio company once the expected marginal return of value creation through his or her own effort and investment is lower than the marginal cost represented by that very effort and investment. Since private equity investors essentially all rely on the same tools, it is questionable why a follow‐on investor would consider such a company a worthwhile investment opportunity. Second, the above‐mentioned increase in SBO activity coincided with the greater liquidity of the leverage markets during the last boom period. This may suggest that SBOs only present an attractive deal option if the second financial sponsor is able to take advantage of attractive debt market conditions to increase the financial risk of the transaction to make up for the reduced operational value creation potential. Finally, critics argue that SBOs are overpriced, since the selling financial sponsor will exercise market timing and negotiation skills to achieve the highest possible value at exit. Taken together, these three arguments paint a very bleak picture of the value creation profile of SBOs, which we call conventional wisdom on value creation in SBOs: SBOs are expected to be more expensive while offering less operational value creation potential than deals sourced elsewhere. This should lead to lower returns, unless the leverage effect is used to inflate returns.

However, recent data from Preqin () show that again in 2010 and 2011 – arguably a period where leverage markets were far from overheated – SBOs accounted for roughly a quarter of all private transactions in terms of deal value. Critics may argue that this was driven by the tremendous overhang in private equity funds that could not be invested during the crisis (Lerner, ). Financial sponsors are under considerable pressure to invest unused funds to catch up on their investment rate and may not act in the interest of investors, the limited partners. Thus a classic agency conflict would be at work, as suggested by Axelson et al. (). On the other hand, financial sponsors may find significant operational value creation potential in an SBO setting, making SBOs a worthwhile investment opportunity, even in times of ‘cold’ debt markets. Two main reasons are generally advanced to explain this. First, the first financial sponsor may be forced to sell the investment early as (i) the fund approaches the end of its lifetime (Sousa, ), (ii) the sponsor aims to generate a tangible track record to facilitate fundraising (Sousa, ; Wang, ), or (iii) the sponsor tries to achieve a stable cash flow profile (Strömberg, ). Second, several authors (Sousa, ; Wang, ) suggest that differing skill sets among financial sponsors allow for different value creation strategies. Both reasons support the hypothesis that SBOs still offer ample room for operational value creation potential.

Overall, it is clear that SBOs are an important yet controversial phenomenon in the realm of private equity and have been therefore identified as one of the most promising research areas in this field (Cumming et al., ; Wright et al., ). To enrich the ongoing discussion on SBOs and their drivers, this paper addresses two main questions. First, it analyses the value creation profile of SBOs compared to that of primary buyouts, considering all three value creation levers: (i) operating performance, (ii) leverage, and (iii) pricing. Then it tests whether SBOs offer lower equity returns than primary buyouts. The analyses are based on a proprietary sample of 2,456 private equity deals (including 448 financial buyouts, i.e. secondary, tertiary or later stage financial buyouts) completed between 1990 and 2010. A total of 1,300 of these deals are realised transactions (including 173 financial buyouts). For most of these deals we have information on the key operating and financial metrics at entry and exit or the last valuation date, all cash flows between a portfolio company and private equity sponsor over the holding period, as well as the net asset value for all unrealised deals on the last valuation date. This allows for the first conclusive analysis of the value creation potential of SBOs using a large dataset of transaction‐level data with granular value creation information to answer the questions of whether and if so how financial sponsors generate value in ‘round two.’

This paper is closely related to three recent working papers that examine empirical evidence on SBOs (Bonini, ; Sousa, ; Wang, ). Bonini () focuses on whether the operating performance of target companies is improved in an SBO and whether the impact is different from that in primary buyouts. Analysing a sample of 111 deals subject to an SBO, the author finds that company operating performance is not meaningfully improved in an SBO compared to industry benchmarks, while there is a significant improvement during the first buyout. Indeed, value creation appears to be mainly driven by leverage as secondary buyers take advantage of (excess) liquidity in the financing markets, which confirms conventional wisdom. Bonini's () sampling strategy is definitely innovative. The author collected data in a panel structure on companies over their entire time in private equity ownership and can therefore easily control for a variety of firm‐specific unobserved effects. However, the analyses focus on the very short performance window of one year prior and one year after the transaction. While this captures the low‐hanging fruit effect, it cannot be used to adequately assess the actual realised performance over the total holding period. Therefore we believe that Bonini's () findings are not sufficient to close the chapter on SBO value creation and accept conventional wisdom yet.

Sousa () and Wang () focus on SBOs from an exit perspective and examine the motives that drive a financial sponsor to sell to a fellow financial sponsor, as opposed to pursuing a trade sale or initial public offering. Both authors find that favourable debt market conditions increase the likelihood of an SBO, which again confirms conventional wisdom. Furthermore, Wang () asserts that the sellers’ need to raise new funds increases the likelihood of SBOs, and some evidence, albeit mixed, suggests that the operating performance of target firms is still increased in an SBO. We take this as initial evidence that SBOs offer continued potential for operational performance improvement.

The remainder of the paper is organised as follows: Section discusses the theoretical rationales for SBOs. Section presents summary statistics for our data. Section focuses on the value creation profile and return impact of SBOs. Section concludes the paper.

2.

The value creation achieved in leveraged buyouts (LBOs) is usually split between three drivers: (i) operational performance improvements, (ii) the leverage effect, and (iii) pricing (Kaplan and Strömberg, ). While the value creation profile of LBOs has increasingly moved into the focus of deal‐level private equity research (see, e.g., Acharya et al., ; Achleitner et al., ), this paper aims to provide a comprehensive discussion of the value creation profile of SBOs compared to that of primary buyouts, leading to a set of testable hypotheses. Since we have in our dataset SBOs as well as some tertiary and even quaternary buyouts (i.e., the third and, respectively, fourth consecutive financial sponsors are purchasing the company from a fellow financial sponsor), we use the term financial buyout in the remainder of the paper.

Operational performance improvements in LBOs comprise all measures that increase the cash flow of the portfolio company, namely, sales growth, margin expansion, as well as the streamlining of capital expenditures and working capital (Kaplan, ). Several studies (e.g., Kaplan, ; Muscarella and Vetsuypens, ) show that private equity‐backed companies outperform peers in terms of operating performance. In an update of Kaplan's () study, Guo et al. () show that operating performance is one of the key value creation drivers in private equity transactions, although their findings on the outperformance of private equity companies compared to that of industry peers is mixed.

Two arguments are generally put forward to explain this improvement in operating performance during private equity ownership: (i) improved incentive alignment as well as governance engineering and, (ii) the provision of smart money and operational engineering by buyout executives (Kaplan and Strömberg, ). Improved incentive alignment is achieved via increased managerial ownership (Leslie and Oyer, ; Muscarella and Vetsuypens, ) and the use of leverage to discipline management and use a firm's free cash flow most effectively (Jensen, ). Governance engineering is achieved through improved reporting...