Buying To Sell: Private Equity Sponsor Exits
November 14, 2016
| Darrell R. Peterson
According to Pitchbook Data, Inc., Canadian private equity sponsor exit activity in 2015 reflected a year-over-year jump of more than 20 percent in volume. In addition, S&P Capital IQ data for Q3 2016 shows a year-over-year increase in transaction value for both M&A and public offering exits. These trends, combined with the fact that close to 36 percent of current sponsor backed inventory dates from 2010 and earlier, suggest that the industry is set to experience a robust exit market over the next few years.
There are six principal types of private equity sponsor exits: trade sales, secondary sales/ buyouts, initial public offerings, redemptions, dividend recapitalizations and write-downs/ write-offs/ bankruptcies. The process for each of these principal types of exits is different and has distinct requirements in respect of the size and characteristics of a portfolio company, execution timing, costs, tax impacts and public disclosure requirements. In addition, the extent of exit can vary between full and partial exits, which are both theoretically possible for each of the six principal types. This paper summarizes the primary process differences and requirements and relative market importance of each principal type of exit.
Exit Alternative 1: Trade Sales
The sale of a portfolio company to a third party such as an industry peer or a competitor is the most common exit type for private equity sponsors. The sale to a third party is frequently referred to as a 'mergers or acquisitions exit' or 'M&A' exit.
The buyer of a company in a trade sale typically is a strategic acquiror. By virtue of operating in the same business, strategic acquirors are best positioned to evaluate the prospects of a business. Accordingly, strategic buyers are often able to pay a premium for companies due to strategic fit and potential synergies.
Trade sales tend to be full exits, typically effecting the sale of the entire company for cash consideration. Partial trade sale exits, although possible, tend to be rare. In such cases, the selling party would typically receive (often illiquid) shares in the acquiror company instead of cash.
From a legal structuring perspective, a sale of a portfolio company can be effected either through a 'share deal', an 'asset deal' or alternatively, a sale to a strategic acquiror could take the form of a merger. The selection of the legal structuring type will be determined by a variety of features, including timing, ease of implementation and tax considerations.
Exit Alternative 2: Secondary Sales/ Buyouts
A secondary sale is an exit whereby only the private equity sponsor sells its interest to a third party, while management and other investors retain their respective stakes in the portfolio company. Secondary sales tend to achieve lower relative purchase prices and thus often generate lower returns than trade sales. Purchasers of a secondary block usually lack the bargaining power of a 100% acquiror to obtain full inside information. Also, transaction synergies are far less likely to be achieved in the case of secondary sales compared to trade sales, mainly due to the fact that buyers are typically unable to integrate and combine the targets' assets with their own.
In contrast to a secondary sale, a secondary buyout denotes an exit transaction where a portfolio company is sold from one financial sponsor to another. Secondary buyouts are a growing phenomenon in the private equity market fueled by the increasing volumes of assets held by private equity firms.
Secondary sales or secondary buyouts are usually full exits for the sponsors only.
Exit Alternative 3: Initial Public Offerings
In an 'Initial Public Offering' (IPO) the portfolio a company sells treasury shares to public investors with a sponsor concurrently selling pursuant to a secondary offering. IPOs are in most cases accompanied by a listing on a stock exchange. Of the different exit types, only an IPO provides a company with an infusion of fresh capital and its shareholders with a high degree of liquidity.
Sponsors often prefer an IPO exit because IPOs typically result in higher valuations for portfolio companies than other possible exits. In addition, although IPOs typically do not result in a full exit for the sponsor, the sponsor benefits from any post-IPO increases in a portfolio company's value.
In most cases, sponsors do not sell all of their shares into the public market right at the time of the public offering but rather undertake a `lock-up' agreement with the investment bank underwriting the offering in which they commit themselves not to sell shares for a period of typically 6 to 12 months following the IPO. Subsequent to the lock-up period, securities are either sold into the market or distributed to investors over a period of months or even years following the public offering.
An IPO process has several notable disadvantages including: (i) the process can be lengthy and take four to six months; (ii) an IPO can be costly and can distract management from their primary job of running the portfolio company's business; and (iii) both during and after the IPO process, the company will be subject to extensive rules and regulations under the various securities regulatory regimes. Noteworthy alternatives to the typical IPO include reverse take-overs and blind capital pool companies:
A reverse take-over (also known as a back-door listing or a reverse merger, RTO) is a type of sale transaction where the shareholders of the portfolio company sell the company to a publicly listed issuer in exchange for shares of the listed issuer, which results in an effective change of control of the public issuer. The publicly listed issuer is frequently referred to as a shell company because often it will be a company whose business has deteriorated and has few assets other than its listing. An RTO does not necessarily include an equity financing component, so it is often used where the principal goal of the transaction is liquidity for shareholders from the stock exchange listing, versus an IPO where capital raising from the public is generally the principal goal.
Alternatively, the publicly listed issuer could be a blind capital pool company like a special purpose acquisition company (SPAC). A SPAC is an investment vehicle allowing the public to invest in companies or industry sectors normally sought by private equity firms. The SPAC program of the Toronto Stock Exchange enables seasoned directors and officers to form a corporation that initially contains no commercial operations or assets other than cash. The SPAC is then listed via an IPO, raising a minimum of $30 million. 90% of the funds raised are placed in escrow, and must then be used toward the acquisition of an operating company or assets within 36 months of listing.
Exit Alternative 4: Redemptions
Sponsors may achieve at least partial liquidity (and possibly complete liquidity) by exercising redemption rights hard-wired into the share terms of the portfolio company. At the time of the initial investment, sponsors can negotiate for redemption rights that allow the fund, at its discretion, to return their shares to the company in exchange for an immediate payout of cash or some other consideration.
Redemption rights give sponsors the ability to get an immediate return of at least a portion of the fund's at-risk capital. In addition, redemption rights typically are priced at a premium providing a return for the sponsor even in a transaction where the fair market value of the equity at the time of redemption is about the same price the fund paid for its initial investment.
However, exercising redemption rights is typically only used in an underperforming investment because the price at which a sponsor can redeem its stock typically provides the fund with lower returns than what were originally expected by the sponsor and promised to the fund's investors; and a sponsor's ability to exercise redemption rights is limited by how much cash the portfolio company has on hand, how much additional debt it can borrow and its ability to pay for the redeemed shares.
In contrast to a redemption, in a buy-back transaction, a sponsor sells its shares back to the company or shareholder group that sold the shares originally. Buy-backs are of greater relevance for early stage investments with relatively low valuations.
Exit Alternative 5: Dividend Recapitalizations
Sponsors may achieve a partial exit from their investment in a portfolio company through a special dividend issued by either the portfolio company to its parent holding company or by the parent holding company itself. The type of dividend is defined by the source the company (or the parent holding company) uses to finance it: a non-leveraged dividend is financed by the company using cash that it already has on hand; a leveraged dividend is financed by the company incurring additional debt.
Although recapitalizations only provide for an exposure reduction of an investor's originally contributed equity capital, such transactions are often undertaken either as a 'prelude' to a later exit or as a temporary alternative to a divestment. Recapitalizations are a popular method to extract some cash from investments, leaving the flexibility to wait and prepare for a potentially more attractive exit later on.
Exit Alternative 6: Write-downs/ Write-offs/ Bankruptcy
A write-down is effected as a form of partial value-correction, where the sponsor recognizes that the investment still has some value, but lacks the originally anticipated upside potential that inspired the initial acquisition. When a write-down occurs, the sponsor will in all likelihood spend very limited or no further effort in restructuring or enhancing the investment.
A write-off occurs when a sponsor walks away from its investment not able to realize its expected returns. This is the exit of last resort and most sponsors will prefer instead to pursue a restructuring through bankruptcy proceeding. A sponsor may be able to recapitalize a distressed portfolio company using the bankruptcy process wiping out debt and unfavourable contracts and leases all for a modest additional investment.
Dual- or Multi-Track Exit Processes
In certain circumstances, sponsors may choose to pursue two or more potential exit routes at the same time. The most frequent dual-track exit process involves the undertaking of an M&A exit auction and an IPO process in parallel. Additionally, private equity sponsors could pursue a dividend recapitalization process at the outset, should a 'real' exit option be unattractive at that time, to still be able to retrieve cash proceeds from an investment.
It is believed that dual- or multi-track exit processes have the potential to generate extra value for the vendors of a company, as they can enhance the competitive dynamics in an auction process. Interested bidders in an auction, knowing about a credible public listing alternative, may be motivated to submit a more attractive offer in order to remain in the auction process.
Furthermore, pursuing more than one exit route maintains the flexibility to execute the alternative that generates the highest value until just before a transaction completion. Particularly in the context of volatile public equity markets, where windows for attractive new issuances open and close quickly, having the option to sell a company at a reasonable price through a trade sale can be valuable.
However, notwithstanding the advantages of a dual- or multi-track exit process, several potential drawbacks and pitfalls exist:
- conflicts of interest of investment banks
- higher transaction costs
- high workload imposed on management and risk of a time delay
- complexity of legal structuring
- IPO track limiting the flexibility of M&A process
- excessive disclosure and publicity
These drawbacks need to be carefully weighed against the potential advantages to a dual- or multi-track exit process.