Two years of limited private equity exits have seemingly come to an end with Q2 this year seeing the highest number since Q1 two years ago. Research by Ernst & Young suggests that global exits are trending upwards with nearly twice as many exits over the first quarter of this year than the same period of last year.
The general economic mood and volatility in the global equity markets has stifled many exits, leaving no doubt that many firms are eagerly awaiting the appropriate time to exit investments.
“The numbers will tell you that there is a backlog of deals that have to happen, as the various funds that own them approach their end date,” says Neil Tregarthen, Chief Executive Officer, NES Engineering.
According to Tim Farazmand, Managing Director – Deal Origination at Lloyds Development Capital (LDC) there are three traditional exit routes for private equity investors – trade sales, secondary buy-outs and initial public offerings (IPOs).
“It is important to remember that, in order to maximise value, you should let the business/business model determine the most appropriate form of exit. For example there are some businesses (those with significant scale have strong visibility of future earnings with a well-respected management team) that will be perfect for IPO or secondary buy-outs. Whereas there are others that may have a more lumpy earnings profile but will excite trade buyers due to ease of integration, level of synergies available or strategic importance,” says Stephen Perkins, former CFO, Hawksmere.
Trade sales and secondary buy-outs have proved to be more popular among firms than IPOs as an exit mechanism, as uncertainty in the global equity markets continue to make pricing a challenge. Such volatility was evidenced last week with the worldwide equity market dips that took place after the respective announcements about the recovery by the US Federal Reserve and the Bank of England.
The only ‘true’ exit route - a trade sale - allows all management and institutional investors to be entirely cashed out.
Tim says, “Over the long-term, this is the exit route for private equity in the vast majority of cases. A private equity investor needs to identify potential trade acquirers early on and work out a plan to engage with this buyer pool on a timely basis. This is to enable the investor to understand the trade buyer’s acquisition criteria and help it position its investee company accordingly.”
Stephen says, “With debt leverage harder to come by, trade buyers have become more active and are looking to source value enhancing acquisitions. They will pay a fair price when they find them and will usually satisfy the price in cash.”
According to Robin Johnson, Partner at Eversheds, trade sales are still far more likely to go through than other types of purchases, as they offer more certainty.
Second, and sometimes third, round private equity buy-outs accounted for 35 per cent of the $101 billion of buy-outs completed worldwide so far this year.
Tim says, “Over the last 10-15 years, it has become increasingly common for private equity investee companies to exit via secondary buy-outs. Typically, this is done on a company-by-company basis albeit there are a number of examples of ‘pools’ of investee companies being acquired from a single private equity investor.
“There is an expectation that the secondary buy-out market could be particularly positive in 2010/11 as there is a ‘wall of money’ that must be invested by private equity funds or else it will have to be returned to the fund investors.”
There is a risk with ‘pass-the-parcel’ type deals that the market will feel negatively about the company in question. However, organisations that end up in these deals may have experienced obstacles to IPOs or might not be in the right position to go to market.
Initial Public Offerings
Although still seen as a traditional exit strategy, an IPO is highly dependent on equity market liquidity and the markets are yet to ‘open up’ fully, making IPOs difficult at the moment.
“I have always espoused a very simplistic view of an IPO as an exit route. If it delivers access to cheaper capital of quoted paper to help finance a consolidation strategy or accelerated organic growth, then it should be considered. If not, then it is best avoided,” says Tim.
The build up of private equity investment mentioned earlier suggests that firms may be looking at more creative ways of exiting than dictated by tradition.
Neil explains, “In the halcyon days of private equity, you didn't have to be too creative because trade buyers, tertiary PE buyers and stock market flotations were all happening at good multiples. The world post Lehman Brothers and the banking crisis is, however, a totally different place and now there is undoubtedly the necessity for creativity! The trouble is that firms are starting from zero in regard to a more creative approach, so it's difficult to change your previous dominant logic about how you exit investments.
“Perhaps we'll see partial exits with houses rolling over some of their investment via seller loan notes, or retaining a stake in a flotation situation and agreeing to sell it when there is an orderly market for the newly quoted shares in the future. Of late, we've even seen some houses doing all equity deals when buying from each other, thus putting a lot of their cash to work - albeit not at the likely stellar returns they generated in the good old days!”
Tim says, “The key point is that a private equity investor needs to do a material amount of work on the future exit strategy ahead of investing. If you don't know how you ultimately are going to exit, then don't invest!”
“On exit there is an interesting dynamic about who is responsible for the deal,” says David Cheyne, Chairman of Criticaleye. “The private equity manager believes it is their job, however they do not know the business as thoroughly as management. Common practice is to keep management focused on their day jobs but there is increasing evidence that having a senior member of the management team assisting the exit team leads to a smoother transaction and greater value for shareholders.”
Stephen says, “Successful exits (in my experience) come about when two things align: 1) Strategy – ie, it is the right time in the businesses evolution/business plan and 2) Management and investors all agree that a liquidity event should occur. If one (or both) of these factors are not in place, then pushing through an exit will be hard work.”
However, it is important for private-equity backed companies to remember that an exit may not always come when it is best for the company. Funds will often exit organisations for their own reasons - for example, as a result of pressure from their own shareholders or legislation. This is why it is vital to know and understand the funds, as well as the environment in which they are operating.
Please get in touch if you have any comments about the issues in today's update.
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