The exit environment recently ranked as the second greatest challenge facing global PE fund managers, according to Preqin’s H1 2017 Outlook report. As buyout firms weigh an uncertain exit outlook, they are increasingly seeking to de-risk early by selling minority stakes in portfolio investments to preferred LPs. Partial exits to LPs have become more common in both Europe and the US, accounting for 24% of all partial exits this year, according to PitchBook.
Why Are Early Partial Exits Popular?
Such deals allow buyout firms to lock in a return, while also sharing in future appreciation of an asset which is expected to continue to perform well. In recent years LPs have sought to ramp up their investment management capabilities, seeking new ways to deploy larger amounts of capital by acquiring a minority stake and taking a more active role in managing an investment alongside a PE sponsor. The investment provides the LP with an early look at an asset that is likely to be on sale in the near future, as well as assisting to cement the relationship between the buyout firm and the LP.
How to Achieve a Successful Early Partial Exit
While every deal is different, deal teams must be alert to common issues including shareholder governance rights, business conduct, board appointment rights and, of critical importance, exit expectations. In our view, the success of an early partial exit depends on careful navigation of the terms and timing of the eventual full exit.
Eventual Exit Valuation – A Key Challenge
A key challenge is misalignment of exit valuations. Incoming minority investors want a significant uplift in the value of their investment on eventual exit. They are concerned about the price a PE firm will eventually sell at, as they know the sponsor is likely to have already receiveda satisfactory return of or on its original investment. Sponsors, on the other hand, want full control over exit, and may be content with a more modest uplift on the early exit price.
There is no perfect way to address the challenge. Minority investors often request a minimum hurdle rate, ensuring an exit is made at a satisfactory return level. In our experience, PE firms are unwilling to cede such control unless the minority stake is significant, preferring to keep their options open to best boost their fund’s returns. A minority investor may also request a minimum hold period, ensuring the majority owner retains the company for a set amount of time in the expectation that value will increase. Once the hold period expires, the challenge returns. A third option is granting the minority investor a right of first offer when the portfolio company eventually comes up for sale. However, this is contingent on the LP being able to buy the asset outright. Some LPs are limited in their ability to acquire majority positions.
The growing numbers of successfully closed early partial exits suggests that parties have been able to navigate the issues. As partial exits rise in popularity, PE firms must carefully balance individual LP relationships with control of returns on fund investments. Engaging with potential misalignment as early as possible and carefully exploring possible solutions will ease partial exit negotiations.