The rapid growth of secondary deals has put the practice increasingly under the spotlight and not always in a positive light. Many investors in private equity funds are vociferous in their dislike of secondaries, especially when holding both the buying and selling fund, which leaves them effectively retaining their original asset, but, as they see it, at a cost. Pass-the-parcel tag lines, distressed sales and below fair-market pricing have also not helped the reputation of this type of deal.
But, what was initially a relatively niche market, is showing a marked evolution as the private equity industry itself matures to deal with changing market conditions. Today, secondary deals are increasingly mainstream, with private equity groups trading assets at or above estimated market values, often as a tool of active portfolio management.
The global credit crisis has been responsible for much of this shift. With stock market listings difficult to achieve and debt less available, secondary deals offer a viable exit route for many funds, allowing them to achieve liquidity and to unravel any remaining unfunded obligations.
In Europe in 2011, for the first time, secondary deals between private equity groups exceeded those of sales to non-private equity buyers and listings combined. In India, where until now secondary deals have represented barely 5% of trades, an upward trend is emerging as companies reach the end of their investment cycles and find opportunities for strategic sales and IPOs few and far between And, undeniably, secondary deals do have attractive features: If the company has had a detail-oriented financial investor in the past, the accounts are likely to be clean; financial management (budgeting, capital allocation) will be more evolved, and governance standards are likely to be high. Equally, the fact that management understands the needs and requirements of a private equity investor from its previous dealings with sponsors (and, in some cases, direct involvement from both private equity and consultants) also shouldnt be underratedmanagement scepticism about private equity value-add can be challenging in a first-round situation.
However, secondary deals also have distinct disadvantages: The earlier investors may have already plucked the low-hanging fruit from the company by achieving a significant number of the cost-improvement measures or by undertaking many of the potential growth initiatives, leaving limited room for the new investor to make an attractive return. The valuation process can also prove frustratingly complex when sellers have high valuation expectations without wanting to give any representations and warranties.
But, at the end of the day, the valuation will be based on the merits of the transaction and not on whether it is a secondary or a primary deal. And with both parties being particularly savvy, its more likely that the deal will get done at a fair price. That said, examples of the primary investor achieving a very good price and the secondary investor struggling to make money and vice-versa are plentiful.
For Advent, occasionally, a secondary deal presents a compelling case for investment. CARE Hospitals, Advents third investment in India, made in April 2012, was just such an exception, where we entered at the mid-stage. The opportunity as we saw it was two-fold, firstly putting capital to work by investing in existing facilities and a growth plan and secondly to simplify the shareholder structure thus allowing Advent and the promoters to develop a clear strategic direction for the future development and growth of the business.
In summary, we believe that while primaries are preferred to secondaries, each deal has to be evaluated on the basis of its own investment thesis and risks. There could be good opportunities in secondaries, especially in emerging markets like India where a lot of early to mid stage funding was done in the last decade and the companies have reached the right size for funds to invest.
The writers are directors at Advent International, a private equity firm that globally manages $10 billion