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Want to Avoid Portfolio Company Bankruptcies? Buy Secondhand.

The risk of financial distress falls when private equity firms sell assets to each other, versus primary buyouts.

New research shows that private equity acquisitions have less risk of financial distress the second time around than their primary buyout predecessors. 

A recently published paper from two University of Cologne scholars defines the risk of financial distress as the risk that a company can no longer operate due to the inability to pay its financial obligations. In other words, bankruptcy — a perennial fear of private equity investors and targets. 

“The prediction of bankruptcy has become an increasingly important topic, especially after economically challenging times such as the financial crisis,” according to the paper.  

This finding matters because the number of secondary buyouts — when a private equity firm sells its stake in a portfolio company to another private equity investor — has skyrocketed in recent years. The researchers noted that in 2018 more than half of buyouts were secondaries. “Even though general partners argue that secondary buyouts are less attractive investment targets... the share of secondary buyouts continuously increases,” according to the paper. 

Researchers Tjark C. Eschenröder and Thomas Hartmann-Wendels used a dataset of 295 primary buyouts and the secondary deals that followed them. They analyzed the risk of financial distress across buyout rounds using an accounting-based default prediction model, the Altman Z-score, according to the paper.  

The data — pulled from Capital IQ, Thomson Reuters Eikon, Preqin, Mergermarket, and a large fund-of-funds manager — consisted of U.K.-based transactions between 1996 and 2017.

While secondary buyouts don’t tend to outperform their primary buyout predecessors, they do show a “significantly lower risk of financial distress.” This, according to the paper, could explain the growth in the secondary buyout market.  

[II Deep Dive: Fundraising Plunges for Private Capital Secondaries Funds]

Primary buyout and secondary buyout investors are driven to reduce risk for different reasons, according to the research.  

Primary buyout investors work to reduce risk by improving profitability, the paper showed. Meanwhile, secondaries investors reduce risk via liquidity management and reducing leverage.  

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