With José Miguel Gaspar
Private equity has experienced tremendous growth over the past three decades; there are some 13,000 private equity funds with around 3 trillion dollars worth of assets under their management. Their success is largely due to their reputation as a relatively fast and efficient way of revitalizing a company while generating considerable returns for their investors. As documented in previous research, private equity funds have superior governance structures and incentive mechanisms and therefore are supposed to act in the best interest of their investors.
Private equity firms raise funds to purchases companies – through a leveraged buyout –by taking on a lot of debt. They use this debt as an incentive to rein in spending and maximize managerial efficiency. After doing the operational improvements to the target company they must then exit their investment -within a set time frame of less than ten years. The most common forms of exits are: relisting the company on the stock market (an IPO), finding a buyer willing to acquire the target, or selling the target to another private equity fund – a secondary buyout.
Among the above types of exit secondary buyouts have experienced the highest rate of growth over the past decade and today constitute more than one-third of all buyout exits. Why do so many private equity funds choose to invest or exit this way and what are its implications for the private equity model?
Secondary Buyouts: Efficient or Opportunistic?
If private equity funds are acting in the best interest of their investors, it should follow that secondary transactions fit within that ideal. The trouble is, efficiency – but also opportunistic motives – can potentially explain why so many private equity funds opt for secondary buyouts.
If, for example, PE funds specialize in different stages of restructuring, then funds specializing in the first stage would sell to those with expertise in the second stage and each fund would create value for its own investors along the way. Alternatively, some general partners may have unique skills that others do not possess and when their funds acquire firms from other funds, they generate additional returns. For example, more reputable funds may have better access to deal financing. However, when a fund is approaching maturity – and the fund manager is under legal requirement to exit the investment – a deal has to be made.
When fund managers are dying to do a deal
Our research found that both pressured buyers and sellers might do deals which are not always in the interests of their investors: buyers are willing to pay higher multiples, use less leverage, and syndicate less while sellers exit at lower multiples and are willing to accept shorter holding periods. Most importantly, our research shows that funds that invested under pressure underperform.
While positive incentives may have the upper hand early in a fund’s life, adverse incentives take the relay as they age. Our research corroborates the notion that agency costs are inevitable even in a sophisticated contractual environment like private equity[i].
These findings should have implications for investments in private equity funds. Once investors commit to invest in private equity funds, they play no active role in the fund’s management, and have no specific information upfront of the investments that the fund will make. In other words investors need to perform thorough due diligence before making investment decisions to mitigate potential risks.
"Fund Managers under Pressure: Rationale and Determinants of Secondary Buyouts" (S. Arcot, Z. Fluck, U. Hege, JM. Gaspar), Journal of Financial Economics, Issue 1
[i] Robinson and Sensoy, 2013