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On Secondary Buyouts, another way to pass-the-parcel

Secondary Buy-Outs (SBOs) are transactions in which a private equity firm sells a portfolio company to another private equity firm. Twenty years ago these were rare, now 40% of private equity exits occur through secondary buyouts (SBOs). The rise of SBOs has elicited concerns among asset owners who provide the capital to private equity firms. In our paper On Secondary Buyouts, forthcoming in the Journal of Financial Economics, we investigate two important concerns.

Research Summary

Investor Concern #1: “SBOs? Just a financial version of pass the parcel.”

One often heard concern among investors is that SBOs are just pass-the-parcel deals in which the main motivations for the buying PE fund are to spend capital and collect fees. This suspicion arises from a certain distinctive feature of private equity funds: they have a finite period in which to invest their capital, after which time general partners usually earn management fees only on the invested portion of the capital committed by investors. This feature generates a conflict of interest between a fund’s general partners and investors: if a fund has excess capital close to the end of the investment period, a general partner has an incentive to “burn money” by taking bad deals. SBOs are plausibly a preferred investment channel for a fund wishing to burn money: they are easier to source than other buyouts (the companies owned by private equity firms are publicly known) and less likely to be “lemons” (any company present in the portfolio of another PE firm is a priori up for sale.)

This concern is valid: we find that SBOs carried out late in the investment period of the buying fund underperform. Investors penalize funds that burn money in SBOs by voting with their feet, reducing their participation in the next fund raised by the same private equity firm.

Investor Concern #2: “How can a second PE owner add value relative to the first PE owner?”

A second often-expressed concern about SBOs is what additional value, if any, the buyer can bring to the portfolio company compared to that brought by the first private equity owner. We uncover an important source of value creation in SBOs: the presence of complementary skill sets between the buyer and the seller. We classify PE firms as finance-oriented or operations-oriented, MBA-dominated or not MBA-dominated, regional or global, and “margin-growers” or “sales growers”. We find that SBO transactions between firms with complementary skill outperform. This concern is not valid.

Research forthcoming

Degeorge, Francois, Martin, Jens and Phalippou, Ludovic (2015) On Secondary Buyouts. Journal of Financial Economics.

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