Financial Poise
Cranes fly over a sunset, representing the desire for Limited Partners to find an exit strategy before General Partners are ready to sell up

The Delayed PE Exit Strategy – What’s a Limited Partner to Do?

The PE Investment Horizon is Getting Longer

The number of private equity exits plunged to just 1,035 in 2019 – the lowest number of exits since 2011 – according to research from PwC. With the worst IPO market since 2012, experts believe that this trend will continue well into the future. PE funds will focus less on their exit strategy, and the average investment horizon will lengthen.

To further illustrate the point, an estimated 8,000 companies in the U.S. are owned by private equity funds, yet more than half of these companies have seen no movement toward an exit in the past decade. As some PE funds increase their holding period up to nearly 20 years (historic PE investment horizons were typically shorter than seven years), what is a limited partner with a correspondingly limited time horizon to do?

The Decline of IPOs as a PE Exit Strategy

Private equity funds have traditionally provided liquidity to their limited partners by taking a larger portfolio company public via an IPO. But the private market has increased in popularity over the past several years as companies choose to remain private for longer. Only 23 IPO exits were executed in 2019.

PwC cites the following reasons for a delayed exit strategy:

  • An inability to meet earnings targets
  • Lofty valuations
  • Fiscal policy gridlock
  • High-profile IPO failures (e.g., WeWork, Peloton, Uber)
  • Record levels of dry powder (unused capital)

Perhaps PE funds can look to utilize the private secondary markets to give LPs their returns and free up their capital.

The Rise of Secondary Exits

In a secondary exit, a PE firm sells its ownership in a company to another PE firm. These are also called secondary buyouts. Currently, secondary exits comprise 40% of all PE exits.

There’s a school of thinking that buyers should be suspicious of invitations to invest in a company that has already raised capital from PE investors. After all, what more could the buyer do for the company, especially if it hasn’t yet burned all the capital from the first raise?

But as companies stay private longer, secondary buyouts are an increasingly common exit strategy as there are fewer and fewer companies that have not been backed by private equity. There are more PE firms today with more capital to invest than ever, increasing the chances for a secondary exit.

Firms can easily justify being second to the table when they add value by addressing areas of expertise or concern that the last PE firm did not. And as long as the exiting LPs can justify their prices, these investments can be attractive, considering their time horizons are often shorter than initial round raises.

Keeping LPs and GPs on the Same Page

What is the moral of the story here? Clearly, it’s more complicated than the assumption that buyers simply aren’t interested. However, PE firms still have to meet the demands of LPs who want to see their returns, and many GPs are stalling in hopes of a better payout down the line. But by creating a better secondary exit strategy now, GPs can create value for buyers much earlier and avoid a longer investment horizon.

In a recent article for McKinsey, Guillaume Cazalaa, Wesley Hayes and Paul Morgan give their advice for PE funds:

“Because exits are critical in securing overall value, PE funds should consider how to instill the same level of discipline and rigor to exits as they apply to purchasing assets. We are encouraged by examples of great exit practices – but we also note that funds do not consistently adhere to the basic elements underpinning a solid exit: articulating a clear equity story with evidence of both the current and future potential of the asset, preparing ahead of time, and adjusting for context and buyers.”

That narrative is especially important for setting a sale price, since private companies will have had little in the way of recent sales to use as comps and because GPs want to keep information about private companies, well, private, as Jean-Marc Cuvilly, a partner at Trivago, told Wharton MBA students.

“We’re dealing with a very inefficient market where pricing is really all over the board,” Cuvilly said in a colloquium called “End Game: What to Do When a Limited Partner Wants Out.”

By creating a strong value narrative, perhaps PE funds can better appeal to both strategic and financial buyers, maintaining strong support for those private companies over a lengthier period of time – while, at the same time, letting the original LP’s fly away freely to light, like butterflies, on their next intriguing investments.

[Editor’s Note: To learn more about this and related topics, you may want to attend the following webinars: What is a “Private Fund?” and Due Diligence Before Investing. This is an updated version of an article originally published on June 11, 2014.]

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