August 12, 2016
Interviewed by: David Snow
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Cambridge’s Auerbach: Don’t Hate Sponsor-to-Sponsor Deals

New research from Cambridge Associates reveals that, on average, deals purchased by private equity firms from other private equity firms outperform. Why is this? Cambridge’s Andrea Auerbach explains the rise of ‘sponsor to sponsor’ deals.

New research from Cambridge Associates reveals that, on average, deals purchased by private equity firms from other private equity firms outperform. Why is this? Cambridge’s Andrea Auerbach explains the rise of ‘sponsor to sponsor’ deals.

Why Sponsor-to-Sponsor Deals Outperform
With Andrea Auerbach of Cambridge Associates

David Snow, Privcap: We’re joined today by Andrea Auerbach of Cambridge Associates. Andrea, it’s always a pleasure to have you on Privcap. Thanks for being here.

Andrea Auerbach, Cambridge Associates: Great to be here.

Snow: You’ve been doing some research into sponsor-to-sponsor transactions. This is an interesting area. It’s a growth area for private equity and yet not everyone has warm fuzzy feelings about it, so I’d love to hear what your findings have been. Before we get to what you’ve discovered about the performance of sponsor-to-sponsor transactions, let’s talk about the fact that they are now becoming a very prominent type of deal within private equity. According to your research, they’ve now crossed the 20% threshold as far as the percentage that they represent in overall private equity deals. Why do you think they have grown as a type of deal?

Auerbach: Private equity as an institutionalized strategy is in its fourth decade, if you will. Over the last 30-ish years, private equity firms have come together to buy companies and then sell companies. Those companies get washed back into the transaction flow and who are the most likely buyers of private companies? Well, you have options of families, corporations—maybe publicly-traded corporations or non-investment entities might be interested. But the one buyer who for certain is going to be looking at what is for sale will be another private equity fund who has a ticking clock on the capital they’ve raised that they have to deploy. So, over a 30-year period, you’re going to have a lot of potential buyers of private equity-backed companies be other private equity funds.

Snow: As the incidence of sponsor-to-sponsor transactions has risen, many limited partners have viewed this and not all of them have a positive image of it. Without necessarily taking sides, why have some investors taken a dim view of sponsor-to-sponsor transactions?

Auerbach: Yes, it’s a really interesting question and it actually was the premise for our work in the subject becausethe general connotation with a sponsor-to-sponsor deal is that it’s not helping anybody except perhaps the sponsor. So, some of the concerns that LPs would have is that, “Look, I own the company in one fund in my program and now that company has simply been sold with friction costs to another fund, also in my program. So, I’m owning the same company over a longer period of time, but sometime in the middle of that ownership, other people came and took value away from me.” And there’s a general concern there.

The other concern we often hear is, “What could another private equity firm possibly do to extract even greater value from a company that’s already been owned by another private equity fund?”

Snow: Right, how many kinds of secret sauce can there possibly be?

Auerbach: Right.

Snow: You looked at a number of sponsor-to-sponsor transactions and you compared the performance of those deals against non sponsor-to-sponsor transactions. What did you discover?

Auerbach: Yes. We discovered that sponsor-to-sponsor transactions do pretty well. In the analysis that we ran, the average and the median sponsor-to-sponsor transaction delivered a 2.6x gross. So, it’s a gross multiple on invested capital and that compares quite favorably. The median sponsor-to-sponsor transaction delivered a 2.6x gross return compared to…an industry median of 1.7x gross return.

Snow: That’s a very significant difference.

Auerbach: That is a lot of headroom. And, if you compare the average sponsor-to-sponsor transaction return of also 2.6x gross, the mean for the industry is 2.3x gross. So, still headroom, and that had really led us to go in and think through what the components are that might be contributing to that.

Snow: Why do you think these deals have outperformed?

Auerbach: In most cases, the sponsor-to-sponsor transactions are really a David—a small, private equity fund selling to a larger private equity fund.

Snow: A Goliath.

Auerbach: Like, yes, a Goliath. Davids are selling primarily to Goliaths. In fact, 70% of the buyers of a sponsor-backed deal were funds of greater than $1 billion or more. So, lower middle-market funds probably selling to upper middle-market or mega-cap funds. There are lots of reasons for that. A small fund might be acquiring a founderowned company and putting institutional processes in place, giving it a proper management team, getting it started on some other longer-term growth trajectory and then runs out of time and runs out of cash. Maybe there’s a huge transformative event that needs to be funded and the fund is at the end of its life and can’t afford to draw capital to support that. So, [it] puts the company into a process and then the next private equity fund picks it up and takes it the rest of the way. That seems to be the logic, the industrial logic, behind why they might typically outperform.

Snow: You mention in your study that investors should be careful or wary of heavy users of sponsor-to-sponsor transactions. What does that mean and why should investors be careful?

Auerbach: As you do this kind of analysis, you start looking for patterns and trying to get a sense of, “Well, if someone’s done one sponsor-to-sponsor deal, how did that do?” Then, let’s see if we have any repeat offenders, so to speak. And what we’ve found is that for those managers that did more than, I think, four or more, the average return those sponsor-to-sponsor deals generated was lower than the 2.6x that we talked about earlier. Not by a lot, but by a little. And it made us pause and think, “The marginal returns of doing a sponsor-to-sponsor deal, if you keep doing them, probably will attenuate somewhat.”

Snow: So, according to your research, the overall percentage of sponsor-to-sponsor transactions in the private equity market is about 20%. Do you see that number going up? If so, by how much and over what amount of time?

Auerbach: The 20% average we’re talking about is for the entire swath of private equity deals being done in the marketplace. And I actually think if you segmented up into the upper middle-market large cap space, that 20% balloons up. It varies from year to year, but I think it’s much higher than the 20% overall average. It might even be as high as 50% in some years in Western Europe, for example.

I do think [that] because there’s a constant stream of previously-owned private equity companies coming into the marketplace and being sold, that 20% average is going to creep up. And particularly for large-cap private equity in that weight class, if you will, I think it’s really going to increase much more. If public-to-privates aren’t available or corporates are less willing to do carve-outs in a significant way or pace, then this is clearly where deals can be had in the large-cap space. So, I think the number is going up.

Snow: If I were an investor who is a refusenik with regard to sponsor-to-sponsor transactions—I didn’t want to take part in it or I was opposed to this frictional-fee effect—how can you even avoid it and still be a participant in the private equity asset class?

Auerbach: Yes. I like your “refusenik” term—it’s a good one. It’s interesting and I think there are two things you can pursue as an LP. One is if you really want to avoid a sponsor-to-sponsor transaction, you’ve just decided that’s not for you, you really need to go into the lower middle market. And the lower part of the lower middle market, where a lot of the companies being purchased are truly from founder-owned, corporate spinouts, family office, etc.

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