Secondary buyouts: Second helpings?

These deals have long been a prevalent feature of developed Western private equity markets – for better or worse. At the height of the secondary buyout boom in Europe in 2006, secondary buyouts comprised up to 48.1% of deal count, and 45.4% of value. They also garnered an unenviable reputation as minimally accretive flipping exercises, driven more by the internal priorities of GPs than any potential for value enhancement post-transaction. These concerns mean that the phenomenon merits some careful scrutiny as it migrates to Asia.

Handoff and successive value creation

The most basic interpretation of a secondary buyout is that it is a natural process in the growth of a private equity-backed company – rather like the hand-off from early stage to later stage specialists in venture capital. In Asia, where private equity has seen a quantum leap in its maturity, scale and sophistication even within the past five years, the opportunity for additional value creation by passing on an asset from one investor to the next may be even greater.

“What I see as a driving factor of Asian secondary buyouts is that a local private equity firm has brought a local company to a certain point where it can spread its wings either regionally or globally, and for that they need a different partner,” notes Dr. Stefan Hepp, CEO and founder of SCM Strategic Capital Management. “They need stage two of the rocket.”

“In Asia, there could be more argument for buyout firms with different skills and resources to take over assets formerly held by another GP, and add another leg to the business,” agrees Jie Gong, VP at Morgan Stanley Alternative Investment Partners.

LPs and advisors alike allow that secondary buyouts have some value enhancement potential. But Jason Sambanju, Director at Paul Capital in Hong Kong, stresses that, “in any secondary buyout, you want to see the acquirer or new owner of the business add value. The most logical times for that to happen would be when a company evolves beyond a certain point.”

However, the argument for generational change in Asian private equity can be overstated. “Some of the more recent entrants arguably have a greater network that they may be able to leverage off, if they’re buying from regional players,” notes Andrew Whan, Partner with Clifford Chance in Hong Kong. “But if you look at who’s been exiting recently, they probably have pretty formidable networks themselves. It’s applicable in some instances, but certainly not all.”

LPs certainly see the current secondary buyout trend in the context of capital overhang and a fallow period for deals in 2008-09. “With the surge in buyout funds raised in 2006-07, there is intense pressure to put money to work since investment periods are ending in one to two years,” affirms Pak-Seng Lai, MD and Head of Asia at Auda International. “Secondary buyouts provide an additional deal source for large buyout funds.”

“We are starting to see some investment pressure mounting on private equity groups in Asia, particularly those who have raised large pools of capital at the top of the market in 2006-07,” confirms Sebastiaan van den Berg, Principal at HarbourVest Partners.

Luckily, the Asian market may have reached just the right cyclical point to meet those needs. “We’re seeing the private equity cycle at a stage where those trail-blazing GPs are in the exit phase of their first, and in some cases their second funds,” says Whan.

The value creation issue

The fact remains though, that secondary buyouts have a lingering image problem – that may be rooted in all-too substantial concerns over returns. “Some people have been complaining about the notion of secondary buyouts,” as regards value creation opportunities and their impact on returns, remarks Brett King, Partner in the Corporate Department at Paul, Hastings, Janofsky & Walker in Hong Kong. Partly, they simply contradict what is seen as private equity’s core value proposition. “A traditional buyout is about building, unleashing and extracting value from businesses,” insists Lai. “Secondary buyouts may be perceived as just recycling and churning of assets.”

But, King adds, “It’s not that simple, because different investors have different views. Some will hold for a long time, some want country exposure for their LPs … There are so many different components to these deals.” And, historic data shows that some of Asia’s most significant secondary buyouts had complicated holding or consortium structures on either the sell or the buy side, with few cases of a direct transfer between single GPs. As such, many Asian secondary buyouts may be closer to primary-and-a-half.

Lucian Wu, MD and Head of Asia at Paul Capital, does believe that, “given the state of development of the Asian private equity market, I would say that there are more [prospects] out here to find secondary opportunities that still have some juice in them.”

Asia’s growth story is, of course, part of the attraction for investing in the region at all. And arguably, a secondary buyer can benefit from that during their ownership period as much as a primary owner could. “There is still more upside just off the growth story than in those other regions,” says Whan. “Having said that, a private equity investor is not likely to execute a secondary if they believe there is no upside over and above that natural growth.”

“Secondary buyouts always attract more scrutiny from LPs,” Jie Gong concludes. “It’s very much case by case whether the new GP is able to give good reasons for this new ownership.”

“Whether secondary buyouts can deliver better returns ultimately depends on the quality and investment experience of the new owner,” van den Berg adds.
Risk and asset testing

Secondary transactions can, in theory, reduce the risk and uncertainty that attend direct investments. This might apply even more in a supposedly high-risk environment like Asia.

“A secondary buyout is a lower risk transaction compared to other vendors. If you know the private equity vendor who helped the company before, you have a better read of how fit the company is,” notes Hepp. “Of course, you pay for this privilege. But if the company has momentum, you may still have a good case to create value, and with less risk to discover problems.”

Secondary buyouts can also solve exit risks for otherwise sound investments that simply do not suit the usual avenues. In Lai’s view, this applies “particularly for certain undersized and specialized businesses where an IPO or trade sale may be problematic.” Regulatory risk can also be lower. “Regulatory approval requirements will likely be less cumbersome to get, as the company is already owned by a private equity group,” points out van den Berg.

However, less risk may well also translate into less reward. Lai sums up the dilemma. “Secondary buyouts may be considered lower risk, since all the hard work is done by the selling private equity firm. However, the question is: what’s left for the buying private equity firm?” As Jie Gong adds, “when these kind of announcements are made, the GPs will try to highlight their differentiated approaches. The proof is in the pudding.”

LP expectations

LPs may come to secondary buyouts with fixed expectations, but experience proves, in van den Berg’s words, that, “it is hard to generalize. We have seen good returns come out of secondary buyouts, but not always. We have even seen tertiary buyouts perform well.”

Secondary buyouts can raise other concerns unconnected to value creation by either buyer or seller. Wu remarks, “It does raise a question of how strong the sourcing capability is.” Lai confirms, “GPs are paid for their proprietary deal sources, and buying from your peers is not exactly proprietary.”
However, the real concern for LPs is usually GPs overpaying. And here, secondary buyouts have seen few significant offenses. “If you look at the track record of private equity in Asia, with a few notable exceptions, I don’t think you see many examples of overpaying,” says King.

The pressure of capital overhang that supposedly drives some GPs into secondary buyouts may actually be less of a problem in the region’s natural venues for these deals, avers Jie Gong. “The capital overhang has eased somewhat compared to 18 months ago before the financial crisis.” She points out that in some mature markets like Japan, private equity firms have actually shut up shop, further reducing the total overhang in the market. “The rebound of private equity liquidity really takes place these days in China and India; less so in the more mature markets,” she concludes.
Market maturity

Finally, almost all sides agree that secondary buyouts, whatever their drivers and their results, are at least a measure of the growing maturity of the Asia Pacific private equity market.

“In Asia the secondary buyout statement is really a mature market statement. You see the majority of that type of deals taking place in Japan,” notes Jie Gong. “Secondary buyouts are a natural evolution of the private equity market in Asia. They provide an additional channel for both deal sourcing and exit,” affirms Auda’s Lai.

Partly, as Whan noted already, this is simply a generational matter. Also, secondary buyouts may underline that the region is driven by private equity industry fundamentals like any other. “I don’t thnk there’s anything about Asia that’s likely to dispose it more or less to secondary buyouts,” believes Sambanju. “The phenomenon is driven by liquidity needs.”

Above all, secondary buyouts may be a sign that GPs, and especially LPs, will have to accept that Asia Pacific, although vibrant and offering rich potential for buildout, is no longer uncharted virgin territory. Returns – and expectations – will have to be more normal and rational in future. “Asia is approaching the point where you do not find the raw diamond any more on the street,” affirms Hepp. “You are in a competitive process. And the process does not only include private equity peers, it also includes cash-rich strategic buyers and the stock market.” 

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• Topics
• Performance
• Exits
• Buyouts
• GPs
• Investments
• Lucian Wu
• HarbourVest Partners
• Paul Capital Partners
• Morgan Stanley