In defence of pass-the-parcel

New research suggests that opposition to secondary buyouts is ‘clearly not justified'.

As the year draws to a close, 2010 will be remembered among other things for the year of the secondary buyout.

Referred to as “pass-the-parcel” deals because they involve assets being passed from one financial sponsor to another, the secondary buyouts have drawn criticism from limited partners and other market participants who argue the deals are often  struck at high prices and provide little scope for further value creation.

Pets at Home: one of this year's large
secondary buyouts

In some instances LPs will find themselves indirectly owning the same asset, which has been passed between two of its GPs with all the associated transaction costs.

This type of deal has continued to court controversy throughout 2010, not least because it has dominated the private equity deal landscape. Private equity funds have in many cases been the most motivated buyers and sellers of companies throughout the downturn.

Recent public criticism of this type of deal has come from the general partner universe from the likes of Guy Hands, chief investment officer of Terra Firma. “Pass-the-parcel deals take substantial value away from LPs – I estimate approximately 20 to 30 percent of equity each time,” Hands told delegates at a conference in November. “And if private equity increasingly goes this route, then it has only itself to blame when governments, unions, employees and eventually investors don’t support it.”

In the first nine months of 2010 in the UK, secondary buyouts accounted for nearly half (44 percent) of total buyout activity, with firms trading £5.5 billion-worth of investments between themselves, according to the Centre for Management Buy-out Research.

Among these deals have been some of the largest private equity-backed buyouts of the year, such as Kohlberg Kravis Roberts’ £955 million (€1.1 billion; $1.5 billion) acquisition of Pets at Home from Bridgepoint in January and Cinven’s €800 million acquisition of medical technology business Sebia from Montagu in March.

Criticism of secondary buyouts may, however, be unjustified, according to recent research from the Technische Universtät Mücnhen in conjunction with Munich-based fund of funds Golding Capital Partners.

Secondary buyouts have historically generated only marginally lower returns than primary buyouts, the research stated. An analysis of 286 realised transactions from Golding’s deal database revealed that secondary buyouts had generated a median IRR of 31.9 percent, compared with 37.9 percent generated by primary investments.

The difference in returns  can largely be put down to the fact that secondary deals are on average larger in size than primary buyouts, and returns are inversely correlated to deal size, said the report. The study also concluded there is “little difference” in the levers for operational value creation between primary and secondary transactions.

“Fundamental opposition to buying companies from private equity funds is clearly not justified,” said Jeremy Golding, managing director of Golding Capital Partners, in a statement. “In the past there was always a question mark about the attractiveness of secondary buyouts. The study provides empirical proof that for private equity funds, secondary transactions are just as attractive as primary buyouts.”