Thursday, November 14, 2013

Exit Strategies for Private Equity

In our recent post, Business Risk, Financial Risk and Attractive LBO Candidates, we discussed the importance of exit strategies and valuations.  Exit strategies refer to the way private equity sponsors hope to sell and exit from the business.  Typically their time horizons are 5-7 years.  If a deal remains on the books much longer than that, the rate of return to the sponsor declines, sometimes dramatically.

Typical exit strategies involve:

1) An initial public offering
2) Leveraged recap
3) Sale to a strategic buyer (in the same industry)
4) Sale to another private equity firm

An initial public offering or IPO can offer the highest rate of return to sponsors if market conditions are optimal.  Note that we listed these as exit mechanisms, but an IPO doesn't necessarily imply an exit.  The shares of the company become publicly traded and thus liquid.  Sponsors can cash out wholly or partially,  but until shares are sold the private equity investor bears market risk.  Depending on the level of equity held, the sponsor can also retain ownership control.

 Similarly, in a leverage recap, the sponsor is not completely exiting, but merely levering the company back up and (generally) using the proceeds to retire equity.  It may be considered a partial exit as the sponsor is able to recover some additional investment.  An advantage is that while getting a return on investment, the sponsor is keeping ownership control.  There are often tax advantages to this method as well.  The disadvantages of high leverage are the increased risk of bankruptcy and loss of financial flexibility.

Sales to a strategic buyer in the industry can provide an efficient method of exit as you are negotiating with just one buyer who is a knowledgable player in your industry.  The seller usually has greater control over the sales process in a sale to a strategic buyer.  However,  existing management may be reluctant for such a sale as there is an increased chance of a change of control (i.e management being replaced). In addition, the loss of competitive secrets is an issue as you are dealing with another firm in the industry.

Finally, the firm could be sold to a financial buyer such as another private equity firm.  By this time, the major cost savings have typically been realized.  A sale in this manner requires the new PE firm to see possibilities unrealized in the first round buyout.

We'll continue our discussion in another post and, of course, in our upcoming Acquisition Finance Course in Amsterdam.

All the best,

Ralph


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