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Private Equity Is Turning Into "Musical Chairs" As Secondary LBOs Skyrocket

The concept of private equity firms buying and selling companies to and from one another has become far more pronounced over the last decade. Increasingly, PE firms find themselves passing around the same company multiple times, tacking on leverage in the process while often paying themselves hefty dividends.

FT highlighted some great examples of this in a recent article. For instance, Gala Bingo – an online bingo and casino company listed in London – merged with a rival in 2005 and was passed around Europe for nearly 10 years, undergoing five different sales between 2002 and 2015. In the process, its leverage continued to increase while successive owners paid themselves handsomely.

A timeline of the company’s history, provided by FT, is as follows:

  • 2002 – Charterhouse buys Coral in a £860m deal, or 10 times ebitda

  • 2003 – Candover and Cinven become new owners of Gala in £1.24bn deal, or 8.6 times ebitda, and a total debt ratio of 5.8 times ebitda

  • 2005 – Candover and Cinven receive dividends of £275m. Permira buys 30 per cent of Gala. Coral is then sold to Gala

  • 2008 – Gala Coral’s net debt reaches 7.4 times ebitda

  • 2010 – A group of lenders led by Apollo takes control of Gala Coral

  • 2011 – The group’s ebitda drops 15 per cent year on year

  • 2015 – Ladbrokes bought Gala Coral in a deal that valued the business at 9.5 times ebitda and net debt at 4.1 times. 

  • 2018 – In March GVC acquired Ladbrokes Coral Group. The Gala and Coral brands now trade separately.

Up until about the time of the global financial crisis, the business was performing well. After that, the past decade has been spent cutting back on locations and laying off employees as a result of market conditions and their leverage. The company eventually went under in 2016, but was rescued by Ladbrokes, who themselves were purchased by GVC Holdings, earlier in 2018.

At a time when you would expect these types of deals to come as a warning sign to the market, it appears the opposite is happening. FT states that in the last year, the industry performed 576 secondary style deals, wherein a private equity firm sells a stake in a company or a whole company, to another private equity firm. This compared to 394 of these transactions prior to the crisis in 2007. Obviously, as interest rates rise and we continue to test the limits of this bubble, the risks of such deals become more pronounced.

Because these deals drain companies of cash and increase their leverage, even small increases in interest rates can have profound aftershocks. A study performed by the Said Business School at Oxford University recently showed that these secondary deals have lower returns than other deals when done by a firm that’s under pressure to deploy capital. The study analyzed 2,137 companies owned by 121 private equity firms.

In essence, what is happening is a dangerous game of musical chairs with these companies.

Neel Sachdev, a leveraged finance partner at the law firm Kirkland & Ellis, told FT: “Every time a company is sold between private equity funds there is a risk that you are taking off some of the potential upside as the business may have been optimised through acquisitions or operational improvements. So there may be less potential upside every time you pass it on. The risk is really that there is not that much juice in the lemon to squeeze.”

Simmons Bedding in the United States is another example of these types of transactions. It was bought and sold seven times over the course of two decades by numerous private equity companies. It filed for Chapter 11 in 2009 and the company had to lay off 25% of its workforce as a result. Regardless, the former owners still made a profit of $750 million through special dividends.

Private equity likes these types of secondary deals because a lot of the due diligence is already done. All you have to do is apply the leverage and take your cut. Per Stromberg, a professor of finance and private equity at the Swedish House of Finance, told FT: “Buyout groups like secondaries because they are buying an asset from a peer and it feels like there is not much work to do. But often this leads to them paying too much.”

Of course, those in the industry like Paul Dolman, a partner at London-based law firm Travers Smithwho has worked on 60 of these types of deals over the past 15 years, make the argument that they’re just fine.

“The key is to work out why the house is selling. If it is because they are under pressure to return money to investors, then you can understand that is a credible reason. If it is because they think the market is about to turn and they have sweated the asset as much as they can, then that is clearly not a good reason,” Dolman stated.

The people who advocate for these deals argue that private equity can bring in necessary injections of capital to help out these companies at their worst points. They point also to successful deals, like vehicle leaser Zenith, who has returned to post great numbers after being owned by four private equity companies. Of course, that wasn’t before one of its private equity owners tripled their initial investment before selling to another firm. Advocates for these deals also argue that they are just part of an industry that is cash flush.

Joana Rocha Scaff, head of European private equity at the investment management firm Neuberger Berman, has a different take.

“When rates rise, pay attention because it may put significant liquidity pressures on these firms. In some cases liquidity is not being fully understood. People are putting a great amount of focus on the capital structure. But where is the cash?” she asked.

Lionel Assant, the European head of private equity at Blackstone (believe it or not) stated that these types of secondary transactions deliver meager returns.

“If the economy slows a bit, the multiples contract and I think investors are going to have very average returns . . . especially on secondary deals. The idea that because you can lever up a business at six or even seven times EBITDA today at a very cheap cost of debt and that you’re going to re-lever with cheap cost of debt in five years from now is obviously ludicrous,” he stated.

We hope, in the future, he takes his own advice.

He also concluded by stating the obvious: the game of musical chairs is fine when companies are being flipped around quickly in a euphoric economic environment, but in a recession, when the music stops, things can quickly go wrong.

“We don’t want to be in this game,” he concluded.