A second look at secondaries

A report suggests secondary buyouts actually deliver better returns than primary deals, with less risk. But M&A activity is crucial – and that’s not easy at the moment

Secondary buyouts don’t always get great press. The practice of GPs buying companies from each other – something that’s becoming increasingly common as managers come under pressure to put money to work  – is sometimes referred to dismissively as “pass-the-parcel” buyouts. 

Some LPs argue that it’s hard for managers to get a good deal this way. As Paul Newsome, executive director and head of private equity investments at Unigestion, puts it: “Due to the competitive nature of the private equity market, attractively priced secondary buyouts with room for material upside coupled with limited downside are a rarity.”

Which is why the results of a new study by the Boston Consulting Group are interesting. The consultancy compared returns from a sample of 225 European private equity deals, and concluded that the median annual return on secondary transactions was actually higher than on primary deals – 24 percent compared to 20 percent. What’s more, these deals tended to be less risky, too.

The study also suggested that M&A was central to the success of a secondary deal. Within the sample set, the median return from secondary deals where there were add-on acquisitions was 25 percent – compared with 15 percent when there was not. 

This is not surprising, says Patrick Knechtli, partner at SL Capital Partners. As there may be less for secondary buyers to do in terms of ‘easy fixes’ or professionalisation, he argues, buy-and-build will often be part of their strategy to grow a business. 

Helen Steers, head of European primary investment at Pantheon, agrees. “The downside of secondaries is that they can be businesses that are ‘too well run’, the ‘low-hanging fruit’ having been picked long ago.” Expanding the business through bolt-on acquisitions, as part of a broader transformation strategy, may therefore be the easiest way to take them to the next level, she suggests.  

Pantheon is a big believer in “transformational” secondaries – for example where a larger pan-regional fund buys a business from a smaller GP and is able to transform it through M&A and other activities; these deals outperform both primary deals and other types of secondaries, the firm reckons.

The trouble is that these buy-and-build strategies are not as easy to pull off as they used to be. According to a report by Silverfleet Capital, also released in February, the volume of European add-ons was down 30 percent last year compared to 2011 – with average disclosed value declining in a similar proportion. 

Nor is there any indication that things will get hugely better in 2013, argues Neil MacDougall, managing partner at Silverfleet. “With the way the European economy is going, buyers aren’t really confident, and sellers aren’t as likely to get a great price.” In addition, he says, healthier stock markets will probably bring more trade buyers into auction processes, making good deals harder to find.

It’s easy to see how secondary deals might provide a better platform for buy-and-build strategies: since the supporting infrastructure is likely to be already in place, the new owner can come in and start doing add-ons from day one.

However, the fact is that the current climate is not terribly conducive to a buy-and-build strategy, as the Silverfleet figures show. GPs will keep doing secondary deals in the next few years, in part because they’ll have to. But they probably won’t be able to rely solely on M&A to create value.