Firms struggle to squeeze value out of tertiary deals

Despite grumbles from investors, such deals – where buyout firms trade companies among themselves – have rocketed this year and now account for about half of all buyouts, according to Nottingham University's Centre for Management Buyout Research.

Furthermore, a growing number of companies have passed through the hands of at least three private equity houses in succession – so-called "tertiary" buyouts. According to research by Financial News and data provider Dealogic, the 10 biggest tertiary buyouts in Europe this year were worth a combined €13bn.

The largest of those was the €3.1bn January acquisition of gaming group Gala Coral by a consortium including Apollo Management and Cerberus Capital Management.
Other large deals between private equity firms include Weetabix owner Lion Capital's acquisition of French food group Picard Surgeles from BC Partners, and the acquisitions of vending products firm Autobar Group by CVC Capital Partners and UK pet supplies retailer Pets at Home by KKR.

The reasons for the rise of follow-on buyouts, where private equity firms sell companies to each other in deals generically known as secondary buyouts, of which tertiary deals are one type, are well documented.
On the supply side, funds raised in the boom years of 2005 to 2006 are now outside their investment window and need a series of exits before their managers can raise a new fund.
Rod Hall, research fellow at the University of Nottingham, said: "Many private equity firms were looking to lock in returns on businesses they had held for five or six years before raising money for new funds."
The high prices achieved on some deals lured more sellers to the market, according to Charlie Johnstone, a director at UK firm ECI Partners.
On the demand side, the financial crisis restricted deal activity last year, so that many firms were nearing the end of their investment periods with large amounts of capital still to invest.
These firms faced a huge drop in fees unless they did deals, because management fees accrue on invested rather than committed capital once investment periods expire. Many firms were therefore desperate to invest even as rivals, such as trade buyers, held back amid an uncertain economic outlook.
Hall said: "The exit market was quite difficult, particularly for larger deals, with little initial public offering activity and very few trade buyers. That left private equity firms as among the only buyers."
These dynamics created an "explosive mix", according to Rainer Ender, managing director at Swiss fund of funds Adveq. He said: "Firms have a significant amount of dry powder, but there is limited deal activity. This is an explosive mix. Secondary buyouts allow both parties to avoid the problem. But they create a closed system."
However, some observers argue that the rise in follow-on buyouts simply reflects the higher proportion of the economy owned by private equity firms.
Jonathan Heathcote, a partner at European private equity firm Palamon Capital, said: "Secondary buyouts are increasing due to the volume of private equity deals out there and the maturity of the UK market. Private equity's share of all companies is much greater now than it was 10 years ago."
Either way, many investors are wary of pass the parcel deals. Ender said: "There are too many secondary buyouts from an investor's perspective. We view them very sceptically."
Investors worry that firms will struggle to add value a second and third time, given that the first firm is likely to have already cut costs and implemented a growth strategy, and to have sold at a high price.
Most private equity executives concede that it is more difficult the second time round. One investor who agreed a large tertiary deal this year said: "To make secondary and tertiary buyouts work, you need a new angle that has not previously been explored. If there is no fuel left in the tank, such deals can turn out badly."
One example of a tertiary investor embarking on a new strategy is Bridgepoint Capital, which paid €838m to acquire French jewellers Histoire d'Or and Marc Orian this year.
It is understood that Bridgepoint would not have bought the companies, both of which previously had two consecutive private equity owners, as individual deals.
But it hopes the merger will create operational synergies, consolidate the French jewellery market and build a platform for European growth.
Ender said: "I support secondary buyouts that take a company from a clear milestone into a new phase of growth, which may be better pursued by a new owner."
But Johnstone argued that private equity was not "a one-off hit". He said: "Firms back growth, and that can be done repeatedly. Secondary buyouts are typically not cheap, but firms are not clever stock-pickers. They help businesses grow."
For their proponents, secondary buyouts simply reflect the dynamics of public markets, where companies attract different investors as they grow. Johnstone said: "Secondary buyouts can be seen as a natural evolution, because as a company grows, its shareholder base changes. Companies listed on Aim have different investors as they grow and reach the FTSE 250, for instance."
Heathcote said: "There is no theoretical limit to the number of times a company can change hands, although most management teams don't ever go beyond three private equity owners."
Moreover, the target company is used to private equity ownership and incentives by the second and third time around, according to Ender.
Investors remain sceptical. Ender said: "Few companies can grow strongly enough to produce private equity-style returns several times in succession. We are most sceptical of partial secondary buyouts, where a firm sells part of its ownership in a company.
That kind of deal looks strange to us. If the offer price is good, why not sell the whole company? If it is a good investment, why not keep it in full? And what does the new manager bring to the table? Such deals tie resources from both parties and make the overall structure more complex. As such they appear to have limited justification for investors."
He added: "Secondary buyout activity will fall as a share of the market once strategic buyers come back and fund managers have less money at hand. That is positive – we need fresh water, not recycled water."