Good things come in small packages, particularly when it comes to cashing out of private equity buyouts made before the financial crisis.

With the eurozone sovereign crisis seemingly impervious to resolution, and global equity markets remaining volatile, private equity sponsors have come to terms with extended holding periods and lower-than-expected sales prices, but many are happy to divest to willing buyers now, rather than wait for a big initial public offering (IPO) payoff, which may never arrive.

“The big-ticket end is difficult because the IPO market is dead, but if you look at the slightly smaller deals it is not actually that grim out there,” says James Barbour-Smith, a partner and head of portfolio management at Gresham Private Equity. “At the right price we have some appetite from trade buyers for high-quality assets.”

Gresham has sold two businesses in recent months: UK-based engineering business Olaer to Parker Hannifin of the US, and specialty stairlift maker Minivator to industry leader Stannah. Both deals followed protracted periods of due diligence and relationship building, reflecting the new best practice for the way private exits are negotiated.

“This is the trend – getting to know the buyers over a period of time, and explaining the business and talking to them, before reaching a sensible price,” says Mr Barbour-Smith. Gresham bought Minivator in 2005, evidence of the slightly longer holding period, to which the industry is becoming accustomed, but eventually made four times its investment. “We had to manage through the crisis, during which time we rescheduled bank debt and renegotiated covenants – it was about battening down the hatches in the downturn and then building growth before exit.”

Gresham’s approach is evidence of how expectations in the private equity landscape have changed over the recent period, after the industry appeared to have emerged intact from the financial crisis in 2011, with general partners able for a short period to avail themselves of the full menu of exit options.

Postponed IPOs

In the second quarter of 2011, the value of IPOs and sponsor-to-sponsor exits hit levels not seen since before the market meltdown, and sales of buyout-backed assets to strategic acquirers soared to record heights, totalling more than $75bn, according to a report by Bain & Company.

The big-ticket end is difficult because the IPO market is dead, but if you look at the slightly smaller deals it is not actually that grim out there

James Barbour-Smith

Favourable exit conditions offered private equity firms a welcome chance to convert unsold portfolio holdings into realised gains. Private equity funds were sitting on a large pool of unrealised capital that had increased to $1800bn by the end of 2010 – nearly four times more than at the end of 2003 – and more than one-and-a-half times the amount of dry powder in private equity fund coffers.

Some of those unrealised investments were still valued either below cost or under the carry hurdle rate, particularly larger companies acquired at high multiples during the peak years of 2005 to 2007. But many assets were ready for sale, having stabilised or improved their performance since the depths of the downturn, and fleet-footed funds took the chance to return money to investors.

Unfortunately, the second quarter of 2011 represented something of a high watermark, and as the eurozone sovereign crisis worsened, the well of enthusiasm for private equity exits dried up. In the second half of last year there were just 76 exits, compared with 176 in the first half, according to Bain & Company.

In the IPO space, some 55% of the year’s planned IPOs were postponed or withdrawn. The challenging environment was encapsulated by sales in the UK, where write-offs accounted for the largest proportion of exits, comprising some 28% of the total, according to financial services lobby group TheCityUK.

One of the most high-profile write-offs was Terra Firma's £1.7bn ($2.67bn) hit on music company EMI, which it ceded to US bank Citi after failing to keep up with loan interest payments. The second largest contributor to exits was trade buyers, at 22%, followed by sales to other private equity firms, accounting for 19% of exits. Public listings accounted for just 6% of UK exits last year.

In the current year, IPO activity has remained muted, particularly since Facebook’s ill-fated flotation in May. Still, the US has fared better than elsewhere, with 44 IPOs in 2012 as of mid-August, compared with just four from financial sponsors in Europe. The exception to the gloomy European landscape was the IPO of Dutch cable firm Ziggo by Warburg Pincus and Cinven, which priced at the top end of the subscription price range.

A lot of the investments that generated decent returns have been sold, leaving portfolios containing things that are not going to show very good returns

Graham Elton

“We tend to see those companies which have performed well achieving very good exits,” says Jeffrey Hinton, head of exclusive sales in mergers and acquisitions at Barclays. “Companies that are not market leaders need to work harder to achieve the valuation goals their private equity owners had hoped for.”

Search for buyers

Sales to strategic buyers, normally the mainstay of global buyout exits, have also struggled to gain momentum, with 200 so far this year in Europe, compared with 298 in the same period last year, according to data provider Dealogic.

The exit bottleneck is aggravating a problem that private equity firms have faced since the financial crisis, which is that they are not returning enough money to limited partners.

Five years into the lifecycle of 2005 vintage funds, the median buyout fund had returned only about 20% of its limited partner’s paid-in capital, according to Bain & Company. At an equivalent point in the lifecycle of the 2001 vintage funds, general partners had distributed more than 70% to their limited partners. The distribution tempo for the 2006 and 2007 vintages has been even slower, with less than 10% of paid-in capital returned to investors.

The sobering reality is that most of the unrealised capital stems from buyouts made in the years before 2008, when investments were made at peak value. That amounts to a huge headache for general partners (GPs), who cannot return cash to investors until they liquidate holdings, but cannot sell at desirable multiples in current market conditions.

“A lot of the investments that generated decent returns have been sold, leaving portfolios containing things that are not going to show very good returns,” says Graham Elton, who heads Bain & Company's private equity practice for Europe, the Middle East and north Africa. “Our analysis shows 80% of what is left will not earn GPs any carry.”

Another impediment is the deleveraging process in the banking system, which makes it difficult for non-cash buyers to get access to funding.

“It used to be the case that you could get significant leverage for financing or refinancing from banks, but that has all changed since 2008,” says David McCorquodale, a corporate finance partner at KPMG. “Now they lend at much lower levels of leverage, for example three times rather than six times previously, and are not in favour of financing simply to pay out the private equity firm. This can make exits and refinancings tricky.”

Trade buyers

Despite the tough environment, however, deals are still being done, and Paul Canning, UK managing director at HIG Private Equity, says the company is in the process of completing two exits – one to a trade buyer (Flemish media concern De Persgroep is buying VNU Media) and a second to another private equity firm, which had not completed at the time of going to press.

“The IPO market is certainly pretty dead but you can find buyers, particularly in the UK where private equity funds have an overhang of capital and where corporates are sitting on large piles of cash,“ says Mr Canning. “In that respect, it is not such a bad environment for exits – especially for small and medium-sized companies.”

One of the key conditions of achieving a sale is to leave some value on the table, so that purchasers can see ways to grow the company further, Mr Canning notes. Still, the recent sale of Hamburg-based healthcare group BNS Medical to Stockholm-based private equity firm EQT Partners is a good illustration of the convoluted process that can be required to achieve an eventual successful exit.

EQT bought BSN from rival Montagu Private Equity in a €1.8bn deal, which was the largest European buyout in the second quarter. Montagu had bought the dressings and bandages maker for €1.03bn in 2005, and funded a management buyout the following year.

After a period of growth, Montagu looked to sell the company, but pulled out of an auction process after the collapse of Lehman Brothers. Soon sales began to fall, and it was not until 2010 that Montagu attempted another sale, this time through an IPO. That was postponed amid negative sentiment connected to the early stages of the eurozone crisis. After another two years of volatility, Montagu again put the company up for sale and attracted several bids before eventually completing with EQT, and making a three times return on its equity investment.

As the divide grows between attractive disposable assets and dead weight sitting on private equity books, general partners must grab the nettle, says Bain & Company’s Mr Elton. “The key decision for private equity firms is either to sell those underperforming assets, or hold for longer and try to make a higher return. If you cannot make 20% in the next 12 months you should cut your losses and sell now.”

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