If there was an enduring theme in 2004 private equity profit taking, it was the secondary buyout, or sponsor-to-sponsor sale. The phenomenon is hardly new to the industry, but its popularity has risen dramatically.

According to The Deal there were more than 80 secondary buyout transactions globally in 2004, roughly double the previous year's total. A majority were announced transactions. Of the total, more than 60 were in the middle market.

Why The Surge?

|A happy set of circumstances that continue to prevail today suggest that secondary buyouts are here to stay. Start with too much money chasing too few deals. Private equity firms raised record amounts of capital in 1999 and 2000. Then the markets crashed and the supply of attractive targets dropped, until the economic recovery in 2003. With a supply-demand imbalance, a market awash with capital overhang, and debt markets scrambling to finance a "pre-owned asset," as the used-car euphemism goes, it's only natural that secondary buyouts have become commonplace. The only thing is, a decade or so ago, there were nowhere near as many private equity funds as there are today.

"Any leveraged buyout fund that has an asset will want to maximize returns on that asset, so if there's a private equity fund that comes along and offers to buy at the best price, that's just the way it works," says Mark Weisdorf, who heads Toronto-based investment advisory firm Mark Weisdorf Associates.

By their dominance of middle-market M&A, buyout firms have come to represent a large part of the industry, some wags say. Thus, secondary buyouts will continue to offer a source of assets, which means that a number of firms may be constantly trading with one another in a sort of endless roundelay.

"Secondary transactions have become a natural route of exit for private equity firms—there is nothing nefarious about the trend," says Franci Blassberg, a partner at Debevoise & Plimpton LLP.

Last year's reported secondary buyouts totaled at least $11 billion, still a small slice of the overall pie. But as private equity funds get bigger—megafunds, take note—the bigger the deals and the more hyperactive they get.

Activity was indeed frenetic throughout 2004. On July 6 alone, there were five secondary leveraged buyouts, including the estimated $350 million LBO of packaging company Kranson Industries Inc. by New York buyout firm AEA Investors Inc. to Code Hennessy & Simmons LLC. In Germany, nearly a fourth of all private equity transactions in 2004 were secondary buyouts. Some had a selling spree. London's Bridgepoint and 3i Group plc each had three deals, as did New York-based Sentinel Capital Partners.

Limited Partners Have Doubts

What's the downside for limited partners? "I can't say that LPs are terribly negative about it, but they aren't overly enthusiastic about it either," says Weisdorf. "If both buyer and seller are general partners in the LP's portfolio and the GPs take a 20 percent carry on both ends after a three-year holding period each, is that really materially different from one fund holding it for six years at 20 percent? I wouldn't think so."

The real question is: Did the buyer overpay, or will it generate the targeted returns? That remains to be seen, Weisdorf says.

This article was written by Vyvyan Tenorio and originally appeared in The Deal.

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