(September 25, 2013) — Private equity firms are increasingly selling their portfolio companies to other private equity firms despite their overall underperformance, according to research.
The transactions, more commonly known as secondary buyouts (SBO), now represent more than 40% of all private equity exits, the study found.
“Is the Rise of Secondary Buyouts Good News for Investors?” written by Francois Degeorge of the University of Lugano, Jens Martin of the University of Amsterdam, and Ludovic Phalippou of Oxford University’s Saïd Business School argued that the underperformance of such a popular strategy is surprising.
Analyzing a sample of over 500 SBOs and over 7000 primary buyouts (PBO), the authors discovered that SBOs generated lower returns than PBOs—0.4 less cash multiple and 15% lower interest rate of return.
The paper outlines three possible reasons for such underperformance: limited value gains for SBO buyers, problems between managers and investors generating incentive to overpay for SBOs, and lower risk of SBOs.
These reasons were consistent with the ‘go for broke’ hypothesis, which argued that fund managers are likely to pay more for exits towards the end of the investment period. The key is to spend all the capital committed before losing it.
An average SBO significantly made lower returns than same-year PBOs, the study found. An SBO saw a return of $2.34 for every $1 invested, while same-year PBOs returned an average of $2.76, or 18% higher.
Degeorge, Martin, and Phalippou found through data analyzed with dummy variables that SBOs made late in their investment period underperformed compared to similar PBOs.
Data showed that the cash multiples of late SBOs were lower by about 0.8, a third of an average cash multiple of 2.1.
When the factor of dry powder, or excess cash, was introduced to the model, the data concluded that its presence magnified the underperformance of late SBOs. Larger late funds saw even lower returns as managers found more incentive to make larger deals.
The researchers also identified seller characteristics and found that specialized bidders, fund raising firms, and companies better suited for private ownership performed better.
Read the entire paper here.
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