Secondary Buyouts — Leverage Play or Real Value Enhancement Potential?

For private equity, 2010 is the year of secondary buyouts. While this type of buyout was until recently considered a phenomenon of the last boom phase, it is now experiencing a renaissance.

Private equity funds are increasingly under pressure to realize their investments, but the traditional exit alternatives of IPOs and trade sales are not very attractive. Often, the only option is to sell the company to a financial investor. This also helps the private equity industry on the buyer side, as it sits on a substantial capital stock (mostly collected before the financial crisis) compared to the still rippling M&A market. Moreover, in times of uncertain economic outlook, many private equity funds focused on stable, proven companies that had already been professionalized by a predecessor. These dynamics, as well as the high leverage of buyout financings in the last boom phase 2005 - 2007, have led to skepticism about secondary buyouts both in academia and in practice. However, while the previous discussion could not draw on empirical analyses, this article shows that secondary buyouts offer significant operational value enhancement potential that is quite comparable to that of primary buyouts, and the returns are not generated by above-average corporate debt.

Meaning of Secondary Buyouts

A corporate transaction in which both the buyer and seller are private equity funds is commonly referred to as a secondary buyout. The 62 importance of secondary buyouts for the private equity market can be estimated by their share of total investments. Based on data for the global leveraged buyout market from Kaplan and Stromberg (2009), Figure 1 shows how the share of secondary buyouts in total investments has evolved over time from 1985 to mid-2007.

In the first boom phase of private equity, 1985 - 1989, secondary buyouts still represented a vanishingly small share of only 2% of the total transaction value. As the private equity market matured, the share of secondary buyouts increased.