Secondary Buyouts: Operating Performance and Investment Determinants

• Date: 01 June 2015
• Author: Stefano Bonini
• Published date: 01 June 2015
• DOI: http://doi.org/10.1111/fima.12086

Secondary Buyouts: Operating

Performance and Investment

Determinants

Stefano Bonini∗

Secondary buyouts (SBOs) now represent over 60% of the overall buyout activity. In this paper,

I investigate the possible determinants of such spectacular growth. I find that first round buyers

generate a large and significant abnormal improvement in operating performance. In contrast,

SBO operating growth is not different from that of its peer group. Returns to secondary private

equity (PE) investors are positive, but significantly lower than those of first round buyers. I

examine several alternative drivers of SBOs and find that favorablecredit market conditions and

PE reputation drive secondary investment volume.

“How well investors are being served by secondary buyouts is [un]clear [ .. . ] the risk of

overpayment in a secondary buyout is great. Once a business has been spruced up by one owner,

there should be less value to be created by the next.”∗

“We have sold the company because we had extracted all the value a private equity investor

could generate.”∗∗

“Investors have grumbled about secondary buyouts [...] because the transaction costs in

buying and selling companies made it expensive for investors in private equity funds [ .. . ] If

secondary buyout companies turn out to be more vulnerable to bankruptcy filings than other

types of deals, the groans will grow louder.”∗∗∗1

Following the substantial growth of the private equity (PE) industry in the 1980s and 1990s,

several theoretical and empirical papers have attempted to explain the economic sources of

returns of buyout transactions and the impact of PE investors on acquired companies (see Wright,

I thank Raghu Rau (Editor), two anonymous referees,Viral Acharya, David Yermack, MarcinKacperczyck, Alexi Savov,

David Robinson, Ludovic Phalippou, Maurizio Dallocchio, Samuel Lee, Cem Demiroglu, and participants at the NYU

Pollack Center for Law & Business, the Bocconi University faculty department seminar, the Luxembourg School of

Finance department seminar, the 2010 EFM Symposium on Entrepreneurial Financeand Venture Capital, the 2011 FMA

Conference, the 2012 ArgentumSymposium on Private Equity, and the 2013 FMA Conference for helpful comments and

suggestions. I am indebted to Fiammetta Rubinacci, Elio Battaglia,Martina Domeniconi, and Andrea Gagliardi for their

excellent researchassistance. I gratefully acknowledge the S&P LCD and Mergermarket for partiallyproviding the data.

This paper has been completed while the author was a Visiting Associate Professorat the NYU-Stern School of Business,

Department of Finance. The ideas expressed in this paper are those of the author and do not necessarily reflect the

position of the author’sinstitutions. Any errors that remain are my own.

∗Stefano Bonini is an Assistant Professor in the Howe School of Business at the Stevens Institute of Technology in

Hoboken, NJ.

1∗“Circular Logic,” The Economist, 2/27/2010; ∗∗Andrea Bonomi, Investindustrial Private Equity CEO, Ducati Sale to

Audi press release, 4/19/2012; ∗∗∗”A Troubling Sign for Secondary Private-Equity Buyouts?” The Wall Street Journal,

3/6/2009.

Financial Management •Summer 2015 •pages 431 - 470

432 Financial Management rSummer 2015

Gilligan, and Amess (2009) for a review). However, established theories have been challenged by

the recent surge of a family of deals known as secondary buyouts (SBOs). SBOs are leveraged

buyouts (LBOs) in which both the buyer and the seller are PE firms. Second round acquirers

provide a new ownership structure including, typically, a new set of PE financiers while the

original financiers, and possibly some of the managers, exit (Cumming, Siegel, and Wright,

2007). SBOs have historically been almost exclusively confined to distressed transactions, as

successful deals would exit through IPOs (initial public offerings) or trade sales (TSs). However,

in the last ten years, PE investors haveincreasingly sought exit by selling initial buyouts to other

PE firms in secondary LBOs, with proportions increasing from 3% of all exits to above 30%.

Though secondary deals briefly declined at the peak of the financial crisis, since 2009, they have

steadily increased to over 60% of all buyouts in the last two years, as shown in Figure 1.

The economic rationale of this spectacular growth and the effects of SBOs on the operating

performance of target companies are both unclear. In particular, the current popular wisdom is

that SBOs have a limited association with operational improvementsand are primarily motivated

by investor-specific characteristics, temporary market conditions, and collaborative dealing be-

tween funds. Surprisingly, empirical evidence on this issue is still scant. Most of the existing

research on buyouts focuses on the US market, where data on private companies are not avail-

able, thus restricting research on this topic to public-to-private transactions, which account for

less than 6% of all LBO transactions, as reported by Stromberg (2007). This data limitation

Figure 1. SBO Market Data

This figure summarizes Secondary Buyout data from 1998 to 2012 provided by S&P LCD (Leverage

Commentary Data). The left axis reports figures for Total SBO activity by volume in bn/USD, while the

right axis reports the fraction of SBO over total BLO activity in percentage terms.

Bonini rSecondary Buyouts 433

substantially reduces the possibility of studying SBOs that, by and large, are private-to-private

transactions.

In this paper, I fill this gap by adding to the literature in five ways. First, a SBO is different

from other acquisitions in that it involves the migration of the same target company from one PE

owner to another. Therefore, the crucial question is whether the second round buyercan generate

a change in performance comparable to that of the first acquirer. Isolating this differential change

requires extreme care and the only approach that allows minimizing endogeneity concerns is a

panel analysis where the same company is tracked throughout both rounds. To the best of my

knowledge, this is the only study that directly adopts a panel data methodology measuring the

operating performance of 163 companies, from one year prior to the first buyout to two years after

the second buyout.2While a contemporaneous paper (Wang, 2012) partially analyzes operating

performance changes in secondary deals comparing heterogeneous first round and second round

transactions, I note that such a research strategy cannot directly measure differences and the

results are prone to significant estimation biases.

In addition, when dealing with the peer sample, I adopt a comprehensive industry-size-year

matching and further test the robustness of my results by running tests on a pre-event per-

formance matched sample as suggested by Barber and Lyons (1996). Under both matching

approaches, I obtain consistent and similar results for operating performance changes of the

target companies measured by 11 financial ratios, computed at the absolute and change levels,

and after adjusting for the within-industry volatility of each ratio to allow accurate compara-

bility across deals. These granular tests robustly indicate that secondary deals do not exhibit

incremental operating performance when compared to the peer sample and substantially un-

derperform first round deals that, in contrast, create signif icant efficiency gains. These results

are in sharp contrast to Wang (2012) who doesn’t find a clear pattern across rounds or versus

the peers.

Moreover, argued by Axelson, Stromberg, and Weisbach (2009), a SBO can be sought as an

exit strategy because of the fund life constraints by first round buyers. In fact, when the end of the

investment period approaches, investors may be forced to expedite the disposal of the company

to return the capital to the limited partners. In such a case, SBOs might be a quicker way out

than a TS or an IPO that can be either too lengthy, face unfavorable market conditions, or both.

Similarly, second round buyers may have an incentive to quickly draw down capital to provide

limited partners with a positive signal on the quality of the investment pipeline, thus building

reputation in a fashion similar to Gompers’ (1996) grandstanding hypothesis. In this paper, I

reject both hypotheses, presenting first-time evidence of the differential performance of targets

conditional upon the buyer’s and seller’s characteristics.

Additionally, despite the absence of incremental operating performance, SBO deals may still

provide significant returns to PE investors. I test this hypothesis by estimating deal valuechanges

for the same target company conditional upon the investmentround. My results robustly illustrate

that returns to PE investors are positive and large for both rounds, but significantly lower for

secondary buyers. These results suggest that PE investors may view SBOs as a “shortcut” to

generate positive returns and maximize their follow-up fundraising. Because SBO target compa-

nies have proven to be solid cash flow generators able to cope with the stringent requirements

of PE owners, investing in such companies, despite the limited room for incremental growth,

can be a rational portfolio diversification strategy where more risky first round investments are

balanced by a significant fraction of less risky deals. This result complements the evidence in

2This is equivalent to 326 stand-alone deals because each company must be target to two consecutive buyouts to be

included in the sample.