Take a Second Look at Secondaries

According to some of the world’s most respected business publications, secondary buyouts (secondaries)—that is, private companies whose ownership passes from one private-equity (PE) sponsor to another—have little to recommend them. Consider a few representative mentions of secondaries—sometimes called “pass-the-parcel” deals—in the business press:

• According to an article in the February 25, 2010, issue of the ¹ 1 See “<a href="http://www.economist.com/node/15580148" target="_blank">Secondary Buyouts Circular Logic: Private-Equity Companies Look to Each Other to Solve Their Problems</a>,” <em>The Economist,</em> February 25, 2010. Notes: 1 See “<a href="http://www.economist.com/node/15580148" target="_blank">Secondary Buyouts Circular Logic: Private-Equity Companies Look to Each Other to Solve Their Problems</a>,” <em>The Economist,</em> February 25, 2010. , “The risk of overpayment in a secondary buyout is great. Once a business has been spruced up by one owner, there should be less value to be created by the next.”

• An article in the April 19, 2010, ² 2 See “<a href="http://www.ft.com/intl/cms/s/0/2406ae10-4b4a-11df-a7ff-00144feab49a.html#axzz2K85aF24g" target="_blank">Secondary Deals Spur Buyout Rebound</a>,” <em>Financial Times,</em> April 19, 2010. Notes: 2 See “<a href="http://www.ft.com/intl/cms/s/0/2406ae10-4b4a-11df-a7ff-00144feab49a.html#axzz2K85aF24g" target="_blank">Secondary Deals Spur Buyout Rebound</a>,” <em>Financial Times,</em> April 19, 2010. asserted that “pass-the-parcel deals can be unpopular with investors, who often have holdings in both the buyer and the seller. In that case the investor ends up owning the same asset with 30 percent of fees and carried interest—a profit share—taken out of the sale.”

• On August 22, 2012, an article on CNNMoney.com³ 3 See “<a href="http://finance.fortune.cnn.com/2012/08/22/private-equity-lbos-hot-potatoes/" target="_blank">More and More LBOs Are Becoming Hot Potatoes</a>,” CNNMoney.com, August 22, 2012. Notes: 3 See “<a href="http://finance.fortune.cnn.com/2012/08/22/private-equity-lbos-hot-potatoes/" target="_blank">More and More LBOs Are Becoming Hot Potatoes</a>,” CNNMoney.com, August 22, 2012. noted that “once a private-equity firm has bought and sold an investment, most private-equity buyers struggle to add value the second time around.”

Such critiques have taken on additional resonance as secondary buyouts have become an increasingly prominent feature of the PE landscape. (See Exhibit 1.) Secondary and later-stage deal volume in the first nine months of 2012 was roughly $56 billion, accounting for 34 percent of PE deal volume, according to Preqin, a clearinghouse for information on alternative investments. Further, activity in secondary and later-stage transactions is likely to remain high for the foreseeable future, owing to the steep decline in the volume of public-to-private deals, the moribund state of the market for initial public offerings (IPOs), continuing efforts by PE firms to deploy capital accumulated during the buyout boom, and pressure from investors for the return of some of the funds they invested in earlier years.