Leveraged buyout investors
While this booklet primarily focuses on topics surrounding secondary transactions in venture capital backed companies, many of the same issues apply to buyout investors. In an economic environment, like today’s, where public and strategic exits are more challenging, and investor syndicates have grown quite large, there are several good rationales to have a secondary investor acquire a minority interest in a business. Some examples of why a leveraged-buyout investor might consider a secondary transaction include:
A co-investor wants liquidity – In the early days of leveraged buyouts, deals often involved just one investor who, along with management, owned all of the equity in a company. In the recent past, however, the number of “club” deals has increased considerably. In conjunction with this rise of syndicated deals, the number of co-investors (often limited partners of a fund) in any deal has grown as well. Quite often, investors develop different views about exit timing or company strategy. In addition, the own liquidity needs of co-investors frequently diverge from those of the controlling shareholders. Allowing an exit to a secondary investor in those situations can be an effective way to address these differences of opinion.
An equity injection is needed – In today’s challenging economic environment, many leveraged companies find themselves close to or in violation of their debt covenants and in need of an equity cure to help address their credit burden. Frequently, in these circumstances, a co-investor’s desire or ability to provide additional equity alongside a sponsor is also challenged. A secondary sale of the co-investment piece to a secondary buyer, who is willing to provide additional follow-on financing, can both protect the position from being wiped out and reduce the funding burden of the sponsor.
An investor wants to monetize a portion of its stake without selling the entire
company – While private equity firms commonly sell their portfolio companies to other private equity investors, there are often circumstances where an investor only wants to liquidate a portion of their position. Secondary investors can provide an alternative source of liquidity in these situations. For example, a private equity fund can sell 20% of its ownership stake in one or more companies in their portfolio while maintaining its remaining ownership. A secondary sale not only allows a private equity firm to return capital
to its limited partners, but it can often provide a markup on the investment and enable it to reallocate capital to other companies within the portfolio.
After a management change, departing executives seek partial liquidity – Private equity backed companies regularly change their executive teams – due to performance issues, personal reasons or an executives decision to take another job. In certain situations, it is reasonable to allow a departing executive to sell their shares to a secondary firm. While the sponsor firm may often want to purchase the shares themselves, in some circumstances, such as if the departure is less than friendly or the sponsor fund is already fully invested,
allowing a secondary fund to price and purchase the shares for sale makes sense.
A private equity firm has outgrown the investment size of their earlier funds – In recent years, several of the most successful private equity firms have grown substantially in size, and many of these firms have outgrown the size of their earlier equity investments. These older investments, often, still take as much time and attention as the larger deals the firm is currently focused on. In these cases, it makes sense for the fund to sell their smaller, older investments to a secondary firm and allow the investment professionals to focus more
time on their larger investments.
Just as employees and investors often have good reasons to consider a secondary transaction, so too do companies. As a company matures, its investor base ages and the company’s need for capital and board expertise change. A secondary transaction can help resolve many issues that companies face.
Retain and motivate employees – Recently, there have been several instances of companies that essentially prevented, or strongly discouraged, existing employees from selling any of their shares in a secondary transaction. As a result, in many of those companies, some employees quit in order to sell their shares. The last thing a company wants to do is create an incentive for its best employees to leave so that they can sell their stock. By allowing employees to sell small amounts of vested shares or options in a secondary transaction, a company can empower their employees with the knowledge that they can receive additional compensation beyond their salary and bonus to help relieve the financial pressures they might face. Permitting employees to sell a portion of their shares on the secondary market can become a huge incentive to stay at a more mature firm versus going to a start up.
Remove or swap an investor who is not supportive of the current strategy or
management – Dysfunctional board dynamics can inhibit value creation. By replacing an
unhappy investor, a secondary transaction can help realign the interests of the investor base
and enable the company to execute on it business objectives.
Clean up the capitalization table – In today’s venture landscape, there are many misaligned capitalization tables with a long list of tired, early investors. A secondary transaction can help clean up a disorderly capitalization table and provide a refreshed investor base for the company. In addition, a secondary sale can help a company manage its number of shareholders. By acquiring several smaller shareholder positions, a secondary investor can help a company avoid public reporting requirements by keeping their shareholder base bellow the maximum number allowed for a private company.
Realign investor interests – In today’s environment of prolonged exit timelines,companies can frequently find themselves in situations where their investors have misaligned interests and investment goals. By providing liquidity to earlier investors, a direct secondary transaction can help a company realign its investor base with an agreed upon exit timing and path.
Assist in follow-on financings – Today, many companies find themselves in the
unfortunate situation of having investors who, although supportive of the company, are unable to provide the necessary follow-on financing needed to sustain growth and development. A secondary transaction can not only provide some liquidity to those investors, but it can also provide the company with the necessary funding to reach its next important milestones.