Returns for sponsor-to-sponsor deals, also known as secondary buyouts, could take a beating in a market downturn because of the generally high levels of leverage that such deals utilise.
Based on an Adams Street Partners study that looked at 500 realised buyout deals in Europe from 2000 to 2015, sponsor-sourced deals – also known as pass-the-parcel transactions – consistently utilise 1x to 2x EBITDA more debt than non-sponsor deals at entry.
Assets acquired from sponsors are also more expensive, transacting approximately one times EBITDA higher than those acquired from other sources. In Adams Street’s view, this could be because the assets are “cleaner” with more diversified revenue streams or have better management teams.
“Given that sponsor-to-sponsor deals have higher entry prices and a reliance on favourable financing markets, investors should wonder whether returns persist under more challenging market conditions,” Mattias de Beau, a partner at Adams Street Partners, told Private Equity International.
While more susceptible to a market downturn, sponsor-to-sponsor deals generated more stable returns with lower losses compared with non-sponsor deals, Adams Street found in its study. Secondary buyouts delivered 2.8x on average from 2013-16, 2.3x from 2009-12 and 1.9x from 2005-08.
This might no longer be the case with slowing economic growth and volatile markets globally, the study warned. This would occur as GPs cannot finance those transactions with the same amount of debt as they have, or they have to pay more for it, de Beau added.
“We’ve been in a relatively benign and favourable investment environment for the past decade,” de Beau noted. “I think we don’t have the final full picture of how these more recent years are going to look when more transactions are realised and in case we run into slightly more challenging times.”
Sponsor-to-sponsor deals made up about 50 percent of deal value and 30 percent of deal volume in the 15 years to 2015, according to the report.
As the European buyout market recovered after the financial crisis in 2008 and returned to growth, so did the frequency and volume of such transactions. The number of transactions increased by 25 percent and the value almost doubled from 2008 to 2018, the report noted.
Sponsor-to-sponsor transactions are more common than other types of deals because they generally move more quickly. The inherent structure of private equity funds – in that they have a finite life which includes buying assets, holding them for a number of years and selling them to liquidate the fund – is one reason behind this, according to de Beau.
“This means it’s relatively easy for other PE firms to track and predict when these assets will be coming back to market,” he said. “It’s a predictable dealflow compared to the primary deals which often take a long time to develop and could sometimes end up without a willing seller.”
Relationships with entrepreneurs or corporate players take longer to cultivate, therefore buying from another sponsor provides more deal certainty, he added.
Another reason behind its popularity among GPs is the asset’s predictability.
“It’s a known asset and there are fewer unknowns,” de Beau said. Often in such deals, a strong management team is already place as well as proper reporting and finance functions – a large part of what has led these types of transactions to generate more stable returns with less volatility, he noted.
For investors, de Beau said the key in such deals is evaluating the underlying manager, their areas of sector expertise and the operational skills that they have in-house to take the business on its next journey.
“It goes back to the GP’s ability to drive value and how they achieve that and if they have the resources in-house to manage the business through a more challenging time,” he said.