What is a Secondary Buyout?
A Secondary Buyout, or “sponsor-to-sponsor deal”, is an exit strategy in private equity wherein the investment (i.e. the portfolio company) is sold to another financial sponsor.
How a Secondary Buyout Works (Step-by-Step)
The term “secondary buyout” refers to a financial sponsor (i.e. a private equity firm) exiting an existing investment by selling its controlling stake in a company to another financial sponsor.
After the sponsor-to-sponsor exit, the portfolio company remains backed by a private equity firm with a new capital structure (and capitalization table). The existing management team usually continues to run the company or is replaced if the new owner views them as unsuited for the role.
Typically, the buyer in the transaction is of larger size than the seller in terms of assets of management (AUM) and other non-monetary resources, such as industry knowledge, relationships, and operating experience.
Often, the larger-sized firm can take on more risks, utilize different strategies, and/or offer more resources to scale the portfolio company for it to reach the next stage of development, which previously might have been difficult to attain.
The business model in the private equity industry requires investments to be exited within a set number of years, which is frequently between three and five years.
However, there has been a recent trend of moving to longer holding periods, where firms—most often family offices and smaller-sized private equity firms—are exiting their investments after five to eight years. The longer time horizon is attributable to long-term operational improvements being the primary value-add in these investments in lieu of debt paydown.
Furthermore, certain firms face less pressure from limited partners (LPs) to quickly exit an investment and realize a profit (and return their initial capital + share of the sale proceeds).
Types of Private Equity LBO Exit Strategies
There are three exit options for private equity firms seeking to exit an investment and realize returns.
- Sale to Strategic → A strategic buyer is a corporate acquirer that frequently operates in the same or an adjacent industry as the target. Exiting to a strategic is typically the least time-consuming while also fetching higher valuations because strategics can and typically will pay a premium for potential synergies.
- Secondary Buyout → The next exit option is a secondary buyout, or “sponsor-to-sponsor” deal. As mentioned earlier, a secondary buyout refers to the sale of a portfolio company to another private firm, i.e. a financial sponsor. Contrary to strategic buyers, financial buyers are unable to pay outsized premiums since synergies cannot be realized, albeit the trend of add-ons has raised the ceiling on the purchase prices that private equity firms can offer to pay. Thus, financial sponsors participating in an auction process for a potential add-on can be more competitive regarding pricing.
- Initial Public Offering (IPO): The third exit option is for the portfolio company to undergo an initial public offering (IPO) and become a publicly traded company. However, the percentage of portfolio companies that are candidates to undergo an IPO is limited relative to the number of buyouts, i.e. an IPO exit tends to be exclusive to top-tier private firms operating in the upper middle market (usually via club deals) and mega-funds such as Carlyle, Blackstone, and KKR.