A Practical Guide to Private Equity Transactions
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12
Secondary buyouts
1 Introduction
In a secondary buyout (often referred to simply as a ‘secondary’), a company
which has already been subject to an existing management buyout is sold by its
existing private equity backers and management to a new company backed by
a separate private equity investor and some or all of the same managers. The
typical feature, therefore, is that there is a change of private equity investor
(and, sometimes, some of the managers), with many or all of the existing
shareholding managers who obtained equity in the rst buyout carrying over
some of their investment into the new buyer vehicle. Whilst the investors and
any managers who are not to continue with the business will sell their shares
for cash, the other managers (often referred to as the ‘rolling managers’) will
choose, or may perhaps be required, to sell their existing shares in exchange,
in part at least, for shares in the new Newco. Of course, there can be many
variants on this typical model, but the key feature is a change of private equity
investor and a broad continuity of managers.
There is no reason why this second buyout company cannot itself later be
sold to another company backed by a third set of investors with some or all
of the same managers (a ‘tertiary’) and so forth. In this chapter, however, we
will refer to all such transactions as a secondary, as the differences between
a secondary and a tertiary is more one of history in terms of the investment
than of form and substance in terms of the principal transactional issues.
There are also some transactions which, on rst impression, look similar to a
secondary – for example where the incoming new investor is a separate fund
within the same private equity stable (which can create some acute conicts
and other sensitivities), or a transaction where an existing private-equity-
backed business is sold to a new company backed by different private equity
investors and a separate management team (i.e. not based principally on roll-
ing managers) – but neither of these is a true secondary for the purpose of
this chapter.
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Secondary buyouts
2 Features of a secondary buyout
2.1 Reasons for a secondary buyout
A secondary is an exit opportunity for the selling private equity investor and an
investment opportunity for the new private equity investor. On rst impression,
a secondary therefore seems a strange transaction. Why is one private equity
investor a willing seller at a particular exit value when another private equity
investor is a willing buyer at that same price? During the 1990s, many investors
were cynical about secondaries on exactly that basis (i.e. that there must always
be a winner and a loser). However, it is now widely acknowledged that there can
be all manner of reasons to justify a secondary from both sides, for example:
The existing investor is reaching the end of its fund life and wishes to realise •
assets in its portfolio.
The investment requires a further injection of capital to take it to the next •
stage and existing funders are either unwilling or unable to back this.
There needs to be succession within the management of the business, and •
the existing investor has less condence in the new team.
There is a change of strategy or of investment prole on the part of the exist-•
ing investor.
There has been an auction to facilitate a sale, and a secondary has emerged •
at a good price and with good prospects of execution.
The new investor believes that it can obtain more value out of the invest-•
ment, for example through their increased sector expertise or other ‘value
a d ds’.
The new investor is attracted to working with a proven management team •
and wishes to invest in a proven business, leading to a very attractive price
being offered.
From the point of view of the rolling managers, a secondary can also present
some useful opportunities, including:
An opportunity to cash in some of the value added to the business (and •
invest those monies in a different way), but with the chance to continue to
have an active stake in the future growth opportunities of a business they
know and understand.
A chance to work with a new investor, and to negotiate investment terms, •
as a more sophisticated and proven management team (which can lead to a
considerably improved offer for management, especially if there is bidding
tension between two or more new backers).
Access to a deeper investment cash resource (particularly relevant if the exist-•
ing investor lacks the funds or has rejected requests for further funding).
The opportunity to raise money and seek growth on the back of a revised •
Business Plan, which may present a very different capital requirement and
risk and reward prole to that which underlay the original transaction.
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Features of a secondary buyout
The chance to address any succession issues within management. Although •
not always the case, a secondary often involves some of the more senior mem-
bers of the management team either exiting completely or reducing their role
and commitment to, and stake in, the business. This has the consequence of
enabling junior colleagues (or sometimes newly appointed buyin candidates)
to take over the principal managerial responsibilities for the business.
In certain market conditions, a secondary may present an exit opportunity •
or, at least, a partial exit opportunity where a full trade sale would either not
be possible, or would not reect the future growth value which management
believes can be achieved in the business.
In some situations, a secondary may facilitate an exit where the investment has •
been underperforming, and the existing private equity investor is no longer will-
ing or able to back the existing venture. This is an opportunity only likely to be
attractive to those investors specialising in rescue and turnaround situations.
1
2.2 Seller conflicts of interest
All the conicts of interest that arise in any buyout, or on any sale of a private-
equity-backed business, arise on a secondary. However, the particular features
of a secondary can often seem to magnify some of these conicts and, in par-
ticular, can cause both sets of conict to arise at the same time.
This issue is made more acute where the rolling managers will have a
higher proportion of the shares in the equity structure of the second Newco
than in the present company (although, in reality, higher gearing in the second
Newco may well mean that this higher equity stake sits behind a more sig-
nicant amount of debt). On the one hand, the rolling managers are, in part,
sellers and have an economic interest in maximising the sale price (at least to
the extent to which they are actually releasing value for themselves as part of
the disposal transaction). However, as a prospective shareholder in the buyer,
they have an interest in keeping the sale price as low as can be negotiated, and
ensuring that any identied risks are left behind or are adequately covered by
all of the sellers (or by warranty insurance paid for by all of the sellers). It is
this dual role of being both seller and buyer which distinguishes their position
from the original buyout (where they were usually only buyers, albeit with
responsibilities as employees, and often directors, of the seller or Target), and
from a trade sale (where their interests will principally be as sellers – particu-
larly if they are not required to have any executive role in the business after the
sale and have no economic interest in it).
In practice, the circumstances surrounding the approach that leads to the
secondary, and the overall sale process, may either alleviate or heighten this
potential conict. Where the selling private equity investor has proposed a
secondary as a feasible exit route, or has persuaded the managers to accept a
1 On different types of investor, see chapter 1, section 2.3.
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Secondary buyouts
signicant rollover so as to maximise the cash proceeds of the selling investor,
then the selling investor will regard the prospect of a secondary buyout more
positively, and will be less concerned that any offer may not be at arm’s length.
In other situations, for example where the approach has come from manage-
ment (or the new investor is associated with management), and the existing
private equity investor had been less focused on a possible sale at the time,
there may be more of a concern that the managers are aware of some oppor-
tunity likely to lead to increased value in the business. Similarly, if the princi-
pal members of the existing management team are also exiting at the time of
the sale, with the secondary leading to a succession of management either to a
second tier or to buyin candidates (or a combination), the selling private equity
investor may be more comfortable that at least some of the managers have a
more perfect alignment with its own economic interests. At the end of the day,
of course, the attractiveness of the price paid is the key factor.
Where these conicts exist, it is usually familiar territory for the selling
investor and the managers. Similar conicts may well have arisen at the time
of the original buyout, where there was a risk that the interests of the managers
were not fully aligned with the interests of the then sellers. These concerns
can be alleviated somewhat if there is a formal sale process (whether or not
an auction). Corporate nance advisers retained in the sale process are often
keen to ensure that the managers are actively co-operating in the best interests
of the sellers as a whole, and not allowing any particular interest they may
have (or hope to have) in the secondary to interfere with the sale process. In
particular, they will usually require that any potential buyers (whether trade
buyers or private equity) only channel approaches to the sellers through the
corporate nance adviser or some other approved route. This is designed to
reduce, or at least postpone, the chance that some or all of the management
team may be tempted to think of themselves more as a buyer than a seller, and
accordingly become aligned more with the second Newco and its funders than
with the sellers. Clearly, this must be matched with the desire on the part of
the other sellers and their corporate nance advisers to obtain a satisfactory
sale. If the secondary offers the best prospect, then it is both important and
sensible (from the selling investor’s and any exiting manager’s perspective) to
allow the necessary degree of collaboration between the rolling managers and
the funders to the secondary Newco.
2.3 The selling private equity investors
In essence, any selling private equity investors would prefer to treat a second-
ary in exactly the same way as any other share sale exit, as discussed in chapter
13. In particular, they would normally seek to take a typical institutional pos-
ition on warranties and indemnities, with each investor agreeing only to war-
rant title to the shares which it is selling, and its capacity to sell them together
with a release of any claims which it may have against the Target group and its
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Features of a secondary buyout
employees (including, of course, the managers). They would not expect to take
any further commercial risk on the history of the investment or its underlying
business.
2
To date, new investors engaging in secondaries have recognised this
approach and have accommodated it, not least because they are familiar with
the same approach themselves on exit. Any gap in the warranty cover may, in
suitable cases, be plugged by warranty insurance to the extent to which insur-
ance is available and covers the risk in question. Given that such a warranty
gap exists, a good-quality disclosure exercise by the management team and
accompanying due diligence exercise will be critical for the secondary Newco
and its funders.
Assuming the customary investor seller position is adopted such that no
commercial warranties are given by the investors, any signicant issues that
arise during due diligence will either be reected in a price adjustment or, in
the most extreme situation, by a complete refusal from the secondary Newco
to buy. Alternatively, to the extent that managers are realising cash on sale, the
issue may be covered by such managers (whether rolling or exiting managers)
agreeing to part of their cash consideration being held in a retention account
to stand behind warranties, indemnities or other provisions addressing those
identied due diligence risks. This inevitably leads to a signicant conict
of interest between the selling private equity investor and the managers (in
particular, rolling managers), particularly if the rolling managers are being
required by the secondary Newco and its funders to roll over a larger propor-
tion of their proceeds than they would wish.
It follows that, in some situations, private equity investors may have to be
more exible to facilitate the deal, for example by agreeing to contribute to
such a retention, or by paying its pro rata share of any costs to insure against
the specic risks. After all, if the alternative is no exit at all, or a reduced price
reecting the worst case scenario for the issue concerned, the exiting investor
may have no alternative to accepting a contingent element to its price. In those
cases, however, the investor will expect any such mechanism to be drafted as
precisely as possible – in particular to ensure that its share of the proceeds
is only available to satisfy a proven claim on the specic issue concerned,
and there is an appropriate cap to the amount of its contribution and a time
limit during which such a claim can be made. Such protections are essential to
enable the private equity fund to provide the clarity and certainty required to
its own ultimate investors.
2.4 Exiting managers
As has already been mentioned, it is not uncommon in a secondary for one
or more of the existing senior members of the management team to leave the
2 For more on the typical investor position on warranties, see chapter 13, section 3.3.
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Secondary buyouts
business (or at least to step down to a non-executive role) and to realise the
whole of his value on exit. This often makes sense, and indeed may well be
one of the factors that drove the secondary in the rst place. For example, a
manager may feel that, for reasons of age or health or ambition, he has added
all he is likely to be able to contribute to the growth of the business, and now
would be a good time to cash in that value and perhaps retire to pursue other
business or personal interests. Similarly, his keenness to see the business adopt
a more expansionary growth strategy (offering perhaps both increased risk and
increased return for the investment) may be less than that of his colleagues,
particularly if this new strategy will take time to implement. Sometimes, a
whole tier of management can exit in this way, and the secondary is one way
of achieving a succession in the management of the business to the next tier.
On other occasions, a particular manager is out of step with other members
of the management team for other reasons. Sometimes, particularly if the exit-
ing manager is still a key member of the management team at the time of the
secondary, he may be expected to stay on for a while in a non-executive or
consultant capacity. This may be particularly useful in dealing with customers,
suppliers, regulators (where relevant) and other key relationships, and assisting
the transition of management to the new team. The precise terms on which any
such continued role in the business will take place (and in particular whether the
exiting manager retains any equity incentive or is required, despite his depart-
ure, to roll over some of his value into the new structure – for example, by way
of loan notes) will be a matter of bespoke negotiation at the time. In other cases,
all concerned are happy for the exiting manager to depart as soon as possible.
It should be borne in mind, however, that an exiting manager is likely to
be in a different position to the selling private equity investor in one particu-
lar way, in that he is likely to have to give commercial warranties as part of
the sale process, and to enter into restrictive covenants. To this extent, he is
like any manager in a typical trade sale of a private-equity-backed business.
However, because he has no interest in the new structure, he is likely to wish
to minimise his exposure in this context as much as possible, and therefore will
most likely have a very different perspective to his rolling colleagues.
3 Implications of a secondary on the legal documentation
3.1 Structure and classes of instrument(s) held
As explained in chapter 3,
3
rolling managers will have two distinct interests in
the new business: a proportion of the institutional strip alongside the new inves-
tors; and a share in the sweet equity (alongside any new managers taking equity
for the rst time). The proportion of the sweet equity to be held by each indi-
vidual manager will be a matter for negotiation, and does not necessarily reect
3 See chapter 3, section 3.5.
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Implications of a secondary on the legal documentation
the proportions in which any rolling managers hold their respective shares in
the institutional strip. The allocation of the sweet equity (as between all man-
agers, whether rolling or new shareholders) is instead determined applying the
same principles which would apply to the allocation of equity value in a regular
management buyout – in other words, based on their anticipated contributions
towards achieving the strategy set out in the new Business Plan, and largely
disregarding the fact that some of those managers may have a separate rolled
interest in the secondary Newco based on value created to date.
Although there is no reason why the rolled investment could not be into
the same class of shares and loan notes as will be taken by the private equity
investor in the secondary Newco (and this is sometimes seen), the rolled invest-
ment will often be represented by a separate class of shares and related loan
notes having the same overall economic rights as the private equity shares
and loan notes, but without the same class rights and other vetoes and protec-
tions. In this way, the private equity investors do not run the risk that rolling
managers will have a say as part of the investor classes (so that, for example,
their shares are not taken into account when determining whether a require-
ment for an ‘investor majority consent’ has been obtained under the articles of
association). In terms of ranking for payment of interest, dividends or capital,
the managers’ rolled investments will usually rank pari passu with the private
equity investor strip (even though it may be in a different class of share and
loan note), although sometimes the commercial circumstances surrounding
the deal may be such that the rolled management investments are subordinated
behind the investments held by the investors.
As highlighted in chapter 3, it is common for a series of loan note and/
or share exchange agreements to be entered into by the rolling managers, to
ensure that they ultimately hold their own shares and loan notes in the correct
corporate entities in the secondary Newco group. Tax considerations will drive
both the structure and the timing of the rolled investment, as is discussed in
more detail in section 3.5 below.
3.2 Implications of departure of manager
The sweet equity and the rolled investment held by the rolling managers are
usually treated differently on the departure of a manager. It should be expected
that the sweet equity will be subject to all the usual clawback arrangements
that would apply to manager shares in a typical buyout, irrespective of whether
the holder of the shares is a new manager or a rolling manager. However, the
rolled equity strip is generally not subject to compulsory transfer provisions
(although it is usual for investors to insist that the voting rights attached to
any rolled equity are removed if the relevant rolling manager ceases to be
employed, as for any leaver who retains equity for whatever reason
4
). Even
4 On voting, see further chapter 5, section 4.3.
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Secondary buyouts
though the manager’s rolled investment may be into different classes of secur-
ities to those held by the investors, such rolled value is nevertheless seen as a
permanent part of the structure of the secondary Newco.
The fact that a manager’s rolled value remains secured within the business
following his or her departure is not always seen as an advantage by a rolling
manager. This is especially the case if some of his non-rolling colleagues were
able to take their value in the business in full at the time of the secondary (in the
form of cash sale proceeds), whereas he has been expected to lock a substantial
proportion of his value into the second Newco until such time as the next exit is
achieved. In effect, should a rolling manager leave after the time of the second-
ary, material value which he has rolled into the secondary Newco will be xed
in that venture even though he is no longer part of the team, and has no particu-
lar ability to inuence the outcome of the investment. For this reason, rolling
managers sometimes wish to negotiate that their rolled loan notes should be
able to be realised if they cease to be employed (either as a general principle, or
at least if they leave in circumstances justifying a ‘Good Leaver’ treatment).
5
As a general rule, any proposals obliging the second Newco to repay the
rolled investment if a rolling manager’s employment ends will be strongly
resisted by the private equity investors. The value rolled over may well be
signicant, and therefore it will not always be practicable for the business to
repay that value. As a result, if the loan notes were repayable on cessation of
employment, this could have the commercial effect of providing dispropor-
tionate security of employment to the rolling manager (i.e. he would never be
dismissed on the basis that the company could not afford to repay the invest-
ment as a consequence of his departure). In practice, the bank funders to the
secondary Newco are unlikely to accept substantial value being repaid to a
manager before exit in this way either. Whilst nding a relatively small sum
to buy out sweet equity may be manageable for both the bank and the investor
(particularly if that equity is to be acquired at cost), seeing subordinated debt
repaid ahead of the bank and the investor is a very different proposition. An
investor will most usually argue that this is part of the bargain when taking a
share of the institutional strip.
Whether there is any scope for loan notes being repaid on departure is a
matter of bargaining power and negotiation between the parties. The best that
management might expect is some form of non-binding side letter, stating that
if the employment ends (either generally, or perhaps limited to a ‘Good Leaver’
situation) there is an understanding that the loan notes will be repaid if pos-
sible, but without giving rise to a formal contractual debt capable of demand.
Any such repayment would also be stated to be subject to bank consent, and
perhaps to a requirement that the directors (or the private equity investor) are
of the view that it would not adversely prejudice the business or prospects of
the group going forward.
5 For more on Good/Bad Leaver treatment, see chapter 5, section 4.11.
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Implications of a secondary on the legal documentation
3.3 Negotiation of terms: use of equity termsheet or questionnaire
One of the perceived advantages for management of a secondary is their ability
to negotiate an improved deal with the new private equity investor, in rela-
tion both to their economic interest in the structure, and also the restrictions
or other provisions in the equity documentation and service agreements. The
rolling managers will already have some experience of working with private
equity, and there may well be particular issues which have proven to be a
problem in their relationship with the existing investor. The managers may
also feel that a proven business which has already delivered against a previous
Business Plan (assuming that is the case) should be subject to less stringent
restrictions or underperformance provisions second time around. Further, as
the rolling managers will be rolling real value into the new structure, this may
well change not only the bargaining power between the parties, but also some
of the alignment and thinking which underlies the more typical stance taken in
a buyout, where the only stake which the managers will hold in Newco is sweet
equity.
Often, the new private equity investor will offer to adhere to the same pos-
ition as was agreed on the original transaction on key issues such as ‘Good
Leaver’ and ‘Bad Leaver’, restrictive covenants and so on. This is usually put
forward as an advantage, on the basis that it will enable the documents to
be agreed more quickly, particularly if the dialogue between the new private
equity investor and the managers takes place only after exclusivity has been
granted, and at a time when there is considerable pressure from the sellers to
close the transaction. Whilst there are undoubtedly advantages in following
the original deal, management and their advisers should consider whether any
specic provisions ought to change in the new environment or, perhaps, to
reect changes in market practice since the rst buyout.
In many ways, an equity questionnaire or termsheet is even more import-
ant in a secondary than in a normal buyout. A secondary may well arise in a
competitive situation – either because both trade and private equity buyers are
looking at a business, or as a result of two or more private equity buyers com-
peting for the same opportunity. In this situation, provided that the sale pro-
cess allows it, the rolling managers will often look to elicit at an early stage the
position of the potential investors on some of the key issues that typically arise
when negotiating the investment agreement, articles of association and service
agreements. Clearly, there can be a strategic advantage for the rolling man-
agers in creating some competitive tension between private equity bidders in
this scenario. As a consequence, when compared with a primary buyout, any
equity termsheet or questionnaire is more likely to be driven by management’s
advisers rather than by advisers to the private equity investor on a secondary.
The termsheet may effectively serve as a ‘wish list’ for management, or may
alternatively take the form of a questionnaire requesting investors to conrm
their position on key points, thus enabling the rolling managers to compare
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Secondary buyouts
rival bids (and perhaps to choose those aspects which appeal from the different
proposals for negotiation with the nal selected bidder). If a termsheet can be
nalised before exclusivity is granted to any particular bidder then it can be a
very effective negotiation tool in a competitive process.
However, this approach does not always align with the best interests of the
other sellers. Where there are sensitivities around the conict of interests that
might arise for the rolling managers, or indeed a concern as to whether a sale
process will be successful at all, the other sellers may seek to limit or prevent
this more detailed dialogue between the new investors and management until
exclusivity has been granted to a preferred bidder. The process will vary accord-
ing to the competitiveness of the sale process, the relationship between the roll-
ing managers and the other sellers, and their respective bargaining power.
3.4 Warranty cover
One key area where there will often be a departure from the previous deal is
in respect of warranty limitations. As for any buyout, it is necessary on a sec-
ondary to distinguish the warranties given in the acquisition agreement from the
warranties given in the investment agreement. The warranties in the acquisition
agreement are given to the buying Newco by the sellers, and in general terms
cover matters relating to the historic affairs and liabilities of the Target group.
6
The warranties in the investment agreement are given by the managers to the
investors, and are predominantly designed to enable the investors to elicit details
of the manager’s personal history, and any information the managers may have
which qualies the due diligence reports or the Business Plan.
7
On a secondary, of
course, each of the rolling managers will be a warrantor under both documents.
As discussed in chapter 5,
8
the monetary limit on the liability of a manager
under the investment agreement warranties is typically based on a multiple of
that manager’s annual salary (two times salary being a regular compromise pos-
ition). In the context of a secondary, for any new manager who is only taking
sweet equity and is not rolling any investment the same stance may be expected.
However, where there are rolling managers, this particular monetary limit may
not be considered to be appropriate by the investors for those individuals. Private
equity investors are keen to ensure there is some potential pain in the investment
warranties, so that the managers take the due diligence and disclosure exercises
seriously. Where they have cash from the sale, a limit based simply on a multiple
of salary may not be sufciently large to create that pressure.
Where the rolling managers have a strong negotiating position, any sug-
gestion that their liability for investment agreement warranties should be
higher than that of the new managers investing for sweet equity may well be
resisted. It might be argued that their exposure under the acquisition agreement
6 See chapter 4, section 2.7.
7 See chapter 5, section 3.4.
8 See chapter 5, section 3.6.