Performance of Private Equity-Backed IPOs. Evidence from the UK after the financial crisis

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Chapter 2.2.2.3 Sponsor-to-Sponsor Sale (Secondary Buyout):

In a sponsor-to-sponsor sale, also known as secondary buyout, the held portfolio firm is sold to another PE firm. Research suggests that the buy-side PE firm recognises further upside potential to enhance operational efficiencies or create other value measures. Kaplan and Strömberg (Leveraged Buyouts and Private Equity, 2009), who assessed the evolution of the global PE market, find that secondary buyouts have grown from 2% of total exit enterprise value (EV) in the first PE boom period (1985 to 1989) up to 25% in the second PE boom period (2005-2007). However, the increasing popularity of secondary buyouts faces certain skepticism (Wang, 2012; Degeorge, Martin, & Phalippou, 2016). As the typical value drivers in a LBO are: (1) leverage, (2) performance improvements and (3) active management monitoring (Jensen, Eclipse of the Public Corporation, 1989; Lehn & Poulsen, 1989; Baker & Wruck, 1991), Wang (2012) argues that a secondary buyout provides only limited potential to the firm’s leverage and governance structures, since the first PE firm already realised ‘low-hanging fruit’ value drivers and ‘picked the lemons’ (Achleitner & Figge, 2014). While the above mentioned arguments may not uphold to explain the determinants of secondary buyouts, Wang (2012) finds that these buyouts serve no other purpose than alleviating financial needs of PE firms. This is consistent with Achleitner and Figge (2014), who studied whether secondary buyouts have value creation profiles and provide returns different from primary buyouts. They argue, that the limited value creation potential is compensated by higher financial risk which is possible to exploit in highly liquid markets with attractive debt market conditions which allow financial sponsors to finance secondary buyouts with 28% to 30% more leverage (Debt/EBITDA) than other buyouts. Besides, secondary buyouts are 6% to 9% more expensive, since sell-side PE firm’s exploit market timing and negotiation skills to achieve highest possible exit values (Achleitner & Figge, 2014; Wang, 2012). Although, practical and research communities were questioning the ability of secondary buyouts to generate similar returns to primary buyouts, Achleitner and Figge (2014) show equity returns and operational efficiency improvements to be comparable with such of primary buyouts. Finally, Wang (2012) shows that PE portfolio firms are more likely to be exited via a secondary buyout when equity markets are rather ‘cold’.
2.3 IPO Activity:

An IPO is a well-planned process that is led by the ECM division of an investment bank, which not only is time consuming, but also costly for all parties involved (Jung & Jyoti, 2018).
Moreover, as IPO literature predominantly focuses towards the drivers and reasons of going public, Tian (2012) and Lammi (2016) argue, that from a firm’s perspective the most common motive of going public is to raise expansion capital, whereas for founders and shareholders the decision is associated in raising cash to create liquidity. Ritter and Welch (2002) differentiate between two theories to explain the dynamics behind the decision of going public: life-cycle theories and market-timing theories.
Life-cycle theories tend to explain IPO activitiy with different stages in a company’s growth phase. The rationale is that every entrepreneurial idea, which is fed with private, typically venture capital, and where the objective is financial growth, once will go public to finance future expansion after outgrowing a certain stage of development (Jain & Kini, The Life Cycle of Initial Public Offering Firms, 1999). While this theory seems plausible, it fails to explain why numerous large companies remain private (Pagano, Panetta, & Zingales, 1998). Therefore, it does not surprise that literature finds mixed evidence on determinants for companies to go public. For instance, Jain and Kini (The Post-Issue Operating Performance of IPO Firms, 1994) find that U.S. start-ups go public to finance future growth (Jain & Kini, The Post-Issue Operating Performance of IPO Firms, 1994). Contrary, Pagano, Panetta and Zingales (1998) in a sample of Italian IPOs find evidence that companies seek IPOs to rebalance financial accounts after periods of high spendings to finance investments and growth. Another plausible explanation suggests that an IPO represents the first stage in a firm’s sale (Zingales, 1995), therefore firms seek flotation to obtain market value for their assets, which is achieved by either gradually selling ownership through time or in total. Finally, another determinant of a company to go public is that entrepreneurial investors or company founders have superior information on their portfolio firm’s growth prospects, that is why in case of limited or declining future projections they divest their holdings by flotation before the firm experiences a slowdown in growth, and eventually fails as does one third of all IPOs according to Jain and Kini (1999).