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The recycling bin

Leveraged-buyout shops increasingly are trading portfolio companies among themselves. Is this wise?

For all the mystique surrounding leveraged buyouts, the idea behind them is pretty simple: Buy an undervalued company, using mostly borrowed money; then slash costs, improve operations and sell it to a strategic acquirer or stock market investors at a huge profit. But lately, with corporations still wary about acquisitions and the IPO market wobbly at best, LBO firms are increasingly exiting investments by selling to other buyout shops.

That's causing more than a little concern among the large institutions that pay hefty fees for the above-market returns that LBO funds seek. After all, why would a company that's already been through the leverage-and-efficiency wringer be considered an attractive buyout candidate again?

"We have all wondered if these transactions make sense or if they are just the easiest deals to do," says Kevin Delbridge, a managing director at HarbourVest Partners, a Boston fund of LBO funds.

Delbridge and other private equity investors are scrutinizing financial sponsors' deal making, now that the volume of these secondary buyouts has increased to as much as 25 percent of all private equity exits, according to his calculations. As of November 30, there have been 77 such transactions in the U.S. this year, valued at $18.9 billion, according to New York research firm Dealogic. That's up from only 18 deals, worth $6.3 billion, in 2003, the first year Dealogic began tracking them.

Some notable examples: Apollo Management's $1.2 billion pur-chase of Borden Chemical from Kohlberg Kravis Roberts & Co. in August; and Thomas H. Lee Partners' $1.75 billion buyout of Nortek Holdings from Kelso & Co. (which paid $1.6 billion for it in January 2003), also in August.

Despite their concerns, investors are warming to these transactions. For buyers, one plus is that the companies in question have already been overhauled and are accustomed to operating with high leverage. In short, there may be less risk than with a traditional buyout. But that doesn't necessarily mean no upside.

After all, notes Erik Hirsch, chief investment officer at Hamilton Lane Advisors, a consultant to and investor in private equity funds, "if we argue that LBO fund A squeezes all the value out of company B like juice from a lemon, that fund would never be able to sell an asset to strategic buyers or stock market investors."

Some LBO firms recognize that investors are wary of secondary buyouts. At Thomas H. Lee's annual meeting in November, firm executives made a point of spelling out the rationale to limited partners. "There had been a bit of unease that their deals were just warmed-over leftovers, but I think most of us felt more comfortable afterwards," says one investor who was there.

Of particular concern has been Lee's $1.1 billion purchase a year ago of Simmons Mattress. The firm became Simmons' fifth private-equity-fund parent when it acquired the company from Fenway Partners. Scott Schoen, Lee's co-president, says the firm has improved Simmons' business by unloading some of its retailing operations and now wants to boost its brand value by buying back licensing rights. Lee has also upgraded its board, tapping consumer products executives as independent directors. "We worry less about the source of a deal than the opportunity for us to add value and generate returns," Schoen explains.

Absent any truly disastrous deals so far, limited partners seem to be coming to terms with secondary buyouts.

"Would I rather see strategic investors buy portfolio companies, and rather see funds source their deals from the broader market? Absolutely," says William Walsh, a partner at Darien, Connecticut, institutional investment firm Portfolio Advisors. "But so far, the sponsors seem to be adding value to most of these companies."

Indeed, secondary buyouts may remain a permanent fixture in private equity. Even if the IPO market revives and strategic acquirers jump back into the fray, some companies aren't natural fits for those potential buyers, argues Harold Bogle, head of the global financial sponsors group at Credit Suisse First Boston. As cash continues to flow into private equity firms, he says, that is creating a different kind of market, one in which "more and more players are prepared to own businesses and give them a good home."

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