Structuring the Initial Investment
To maximize returns and control the exit process, private equity sponsors should plan for the exit during the initial investment stage. This includes ensuring sufficient control and liquidity through agreements like board control or veto rights, registration rights, redemption rights, drag-along rights, and tag-along rights. Management incentives are crucial for a successful exit, and equity incentive plans can align the interests of management and the sponsor fund. These plans may include time or performance vesting equity awards, which incentivize management to stay with the portfolio company after the sponsor exits.
When looking to exit, PE funds will need to review how the investment was structured to understand what rights it has to facilitate the exit of the investment and understand how the exit should be structured.
One of the most prevalent exit strategies is a strategic sale. This approach involves selling a portfolio company to a strategic buyer within the same industry or a related one. Strategic sales offer several advantages, including the realization of potential synergies between the strategic buyer and the target company. By integrating the portfolio company with the strategic buyer, the selling fund can often secure a higher return, thanks to the premium paid for the acquisition. Moreover, strategic sales generally have shorter transaction timelines, providing a quicker path to completion and increased deal certainty when compared to other exit strategies, such as initial public offerings (IPOs) or secondary buy-outs. When looking to execute on a strategic sale, the sponsor fund can choose to negotiate with a single buyer or shop the portfolio company in an auction process and receive multiple offers from bidders. While an auction typically provides the selling fund with more control over the sale and the drafting of the transaction documents, the process can take longer to complete as compared to a single-buyer negotiation.
Strategic sales tend to result in a complete exit by the selling fund, which typically effects the sale of the target portfolio company in exchange for cash consideration. Partial strategic sale exits are less common and usually result in the selling fund receiving shares in the strategic buyer instead of straight cash. From a structuring perspective, strategic sales can be effected either though a share sale or asset sale. Alternatively, the parties may decide to execute the sale through a merger of the target portfolio company and the strategic buyer. There are several considerations that may impact the type of transaction structure employed by the parties, including regulatory and tax matters that are beyond the scope of this article.
Another popular exit strategy is the secondary buy-out, which entails selling a portfolio company to another PE fund. In this scenario, the selling fund achieves a full exit, while the target company remains a private entity. Secondary buy-outs are favored for various reasons. For instance, the selling fund may opt to divest its ownership interest in a particular portfolio company to focus on other investments that better align with its strategy. Alternatively, the selling fund may believe that the portfolio company has reached a stage of growth or value where another PE fund is willing to pay a premium for the business. Moreover, the limited availability of exit opportunities through IPOs may influence the decision to pursue a secondary buy-out as the most viable exit option at a given time. Successful secondary buy-outs require rigorous due diligence, effective communication, and alignment of interests between the buying and selling parties.
Challenges posed by a secondary buy-out exit include a limited buyer pool, which can put constraints on the competitive bidding process and potentially result in fewer options for sellers. There may also be resistance from company management, as the purchasing fund will often replace existing management with members of its own team. Furthermore, financial buyers like PE funds may not be able to pay as much as strategic buyers because financial buyers cannot factor synergies into their cost and are less likely to pay a higher premium as a result.
Initial Public Offerings
When structuring the initial investment, PE funds will generally seek to retain the flexibility to sell their ownership stake in a portfolio company. This will typically include the right to cause the portfolio company to undertake an IPO. PE funds often prefer IPO exits because IPOs typically result in higher valuations for portfolio companies as compared to other possible exits. It also allows the PE fund to judge when to exit due to real-time fluctuations in value of the company based on open trading of shares on the public market. When an exit transaction is consummated via an IPO, the PE fund will often continue to maintain a significant stake in the company for a period of time following closing, allowing the fund to benefit from any post-IPO increase in the company’s valuation. Consequently, the PE fund will be subject to exchange rules and securities laws relating to resale restrictions on the post-IPO shares and certain types of related party transactions. In many cases, the PE fund will also be subject to lock-up agreements with the underwriters of the IPO.
In addition, the nature of the ownership stake retained by the PE fund will often impact the approach taken in connection with the rights the fund may want to retain following a portfolio company IPO. Most underwriters will seek to place significant limitations on the rights of PE funds following an IPO over concerns that retaining such rights may negatively impact the marketability of the offering. For this reason, certain rights that benefit the PE fund—such as pre-emptive rights, rights of first refusal, and drag-along and tag-along rights—usually do not survive a portfolio company IPO. However, PE funds will often retain board nomination rights, registration rights, and information rights post-IPO, and they may retain certain veto rights, depending on the level of board control and the size of the retained ownership stake. It is important to note, however, that exiting via an IPO also presents a number of disadvantages. These disadvantages include a lack of a complete exit, increased execution risk, increased transaction timelines, increased transaction costs, and increased regulatory scrutiny and disclosure obligations under various securities regulatory regimes.
In addition to these strategies, PE funds can leverage recapitalizations for partial exits by restructuring the capitalization of portfolio companies. Recapitalizations involve financial maneuvers such as issuing dividends or raising additional debt against the company’s assets. By adjusting the capital structure, PE funds can distribute cash to investors while retaining an ownership stake. Recapitalizations are effective exit strategies when the portfolio company has stable cash flows, valuable assets, and growth potential. However, careful analysis of the company’s financial position, its debt capacity, and market conditions is crucial in implementing this strategy. Another option to partially exit the portfolio company is where the PE fund has a redemption right that allows it to require the portfolio company to repurchase the PE fund’s shares. This right is typically negotiated at the time of initial investment and would require the company to have assets available to repurchase all or a portion of the shares the PE fund holds.
Successful exits are critical for PE funds to achieve their desired returns. By carefully considering the various exit strategies available and analyzing the specific circumstances of each portfolio company, PE funds can optimize their exits and maximize profitability. The key is to understand the market dynamics, assess the potential for synergies, and adapt to changing conditions to execute the most appropriate exit strategy for each investment. Through strategic planning and meticulous execution, PE funds can navigate the complex exit landscape and deliver successful outcomes for themselves and their investors.