Recently, there has been a lot of media attention on the prolonged holding periods of venture-backed companies. Many of these companies have finally sought liquidity for their early investors and employees by initiating initial public offerings in 2019. Trevor Williams most recently commented on the phenomena in his blog post, “Happy to Be a Private Asset Investor.” Longer holding periods for private companies are not unique to venture-backed companies as this trend is also present in the leveraged buyout world. This week’s chart shows that middle market hold times have extended over the last decade, rising from 4.06 years in 2009 to a median hold time of 6.80 years in Q1 19.
Many buyout general partners (GPs) still feel that a five-year hold period is a reasonable expectation. With the median exit coming in just shy of seven years and the top quartile hold period at 10 years in 2018 (meaning 25% of portfolio companies were held for at least this length of time), this historical assumption may need some adjustment. While there is no clear explanation for this trend, several factors come to mind. As valuations continue to rise, GPs are looking for additional ways to create value in the current environment. Specifically, two trends we have seen are the proliferation of buy-and-build strategies as well as corporate carve-outs.
Buy-and-build strategies involve buying a platform company of scale and then acquiring generally smaller companies that lack size and sophistication at cheaper valuations. The lower multiple add-on acquisitions, coupled with the synergies when combined with the platform, allow a GP to blend down purchase price multiples. These transactions bring complexity related to the ability to integrate the businesses. Areas of potential execution risk include integrating IT systems and management teams as well as maintaining customer satisfaction. Even if successful, these buy-and-build transactions can result in an extended exit time for a private equity fund.
The corporate carve-out provides a source of attractive deal flow for many leveraged buyout managers. These opportunities are complex, however, as such businesses need to be separated from their corporate parent. Often without a management team, operations need to be rebuilt so the company can stand on its own. This additional heavy lifting often leads to more execution risk and again can elongate holding periods.
Operational improvements have also become a core focus of most buyout managers. These funds employ teams of former operating executives with expertise in areas such as lean manufacturing, supply chain, information technology and human resources. These functional experts can then be deployed into portfolio companies to help professionalize them and drive more efficient operational performance — hopefully leading to more profitable and resilient businesses. This model takes more time to implement than the traditional playbook, where buyout firms, composed mostly of investment bankers, focused primarily on financial engineering techniques.
Dividend recaps are also a factor worth mentioning. The availability of relatively cheap financing has allowed many GPs to achieve partial liquidity for their fund investors by having portfolio companies take on additional debt while paying out dividends. The fund can then continue to hold a business and realize more of its value. This enables the GP to take some chips off the table, but in some cases can delay an exit.
Of note, many companies hit hard during the financial crisis have seen longer hold periods as they have taken additional time to stabilize their core businesses and return to growth.
With valuation multiples hovering around historic highs, GPs have migrated to more complex deal structures to create value. This has allowed many managers to continue delivering strong fund level performance, but in many cases extended hold periods. Private market investors need to be aware of the consequences of this trend, recognizing patience may be required and in some cases tested.
The material provided here is for informational use only. The views expressed are those of the author, and do not necessarily reflect the views of Penn Mutual Asset Management.
This material is for informational use only. The views expressed are those of the author, and do not necessarily reflect the views of Penn Mutual Asset Management. This material is not intended to be relied upon as a forecast, research or investment advice, and it is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy.
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