Market factors continue to drive an increase in secondary or “sponsor to sponsor” sale transactions, particularly in the middle market and lower middle market where sponsors can argue a growth story still remains.  PitchBook recently reported that in 2012, for the first time, the number of secondary exits outnumbered sales to corporate acquirors.

Sponsor to sponsor sale transactions pose a number of challenges.  Many of the most difficult questions cut to the core of principles that have been fundamental to the historical success of the PE industry: the importance of human capital and the use of meaningful equity investment to align the interests of management and the sponsor.  Secondary exits have a habit of turning traditional approaches on their head, creating obstacles on both the sell-side and the buy-side and forging an unfamiliar landscape that potentially empowers management to act with mixed loyalties in a free agent capacity.

From the perspective of the buy-side, management re-investment^[i] represents an imprimatur, a critical validation of the buy-side valuation, which has often been stretched through an aggressive and competitive sales process.  Management investment may also, and more fundamentally, represent an important part of the purchaser’s financing package.  At the same time, a demand by the buyer for a significant management re-investment can catch management teams by surprise.  Key managers likely have focused intensely on achieving a successful exit over a three to five year period and may have decided to forego significant cash or other current compensation to achieve this goal along the way.  Anything less than full liquidity for these managers may not align with the “story” they have been told.  With these differing outlooks, it can be difficult to forge a new partnership that satisfies both sides.

From the sell side, a transaction that presents management with a decision to re-invest effectively makes management a buyer, not a seller, in the transaction.  Selling sponsors occupy an uncomfortable position across the table from the management team that holds the keys to the business.  From a process perspective, management’s investment decision becomes a key transaction milestone, and when and how that decision comes about are key factors for the selling sponsor in maximizing value.  A buyer’s reinvestment demand puts management in a position to act strategically as a “holdout” and/or causing management to favor one bidder over another based on different consideration that those important to the selling sponsor.  At bottom, without the validation that comes with a decision by management to reinvest, the value of the selling sponsor’s company is diminished.  Rollovers accordingly cut to the heart of the two most important issues for any seller – price and certainty of close.

The following represents some advice we would share with sponsors based on our experience with these transactions:

• Assess the Situation Early – Selling sponsors are well-served to engage in advance planning to flag issues associated with reinvestment ahead of the sale process itself.  Assuming the worst case, that a management team actually is in a position to block a secondary transaction (which with proper front end planning can be avoided, as discussed below), the sponsor is better off knowing up front, so it can structure a sale process, manage its banking team, vet bidders and take the other actions necessary to maximize chances of a succesful sale.
• Pay Attention to Structure… from Management’s Perspective – Tax and other structural issues have the potential to make problems associated with a management rollover either better or worse.  Is the buyer proposing a structure where management can reinvest on a tax-deferred basis?  Is management facing a situation where the reinvestment will trigger a phantom tax?  Will management’s reinvestment be shoulder to shoulder in the capital structure with the new sponsor?  Will the buyer’s structure result in management’s upside being taxed at capital gains rates or ordinary income rates?  Will there be vesting on re-invested securities?   A selling sponsor is better off planning for and managing these issues on an active basis.
• Selling Management on the Buy-Side – On the buy-side, secondary exits create an opportunity for the adept sponsor to compete on something other than price.  We have seen an increasing sophistication on the part of sponsors in learning how to sell incumbent management and tilt a sales process in their favor.  On the sell-side, sponsors need to consider carefully how access to management is managed.
• Consider Non-Traditional Incentive and Closing Structures – In certain cases, we have seen sponsors move away from favoring equity securities as a preferred form of long-term incentive.  Other structures are available and may be preferable.  It may be possible to structure a cash sale bonus, for instance, to correct misaligned incentives, although tax considerations can present problems.  While giving management “extra” cash to fund reinvestment is never fun, it may be better than losing a hot bid.
• Front-End Planning is the Best Solution – We take the view that for a majority owner, there is no more important “control right” than the right to control the sale of the business.  We have developed legal solutions for dealing with strategic behavior by management in an exit transaction, but these solutions require attention (or, as the saying goes, a “focus on the exit”) at the front-end of the transaction – that is, at the time the selling sponsor initially acquires the company.  At the time of an exit transaction, equity rights have become embedded, and the difficulties become much greater.

In summary, secondary sale transactions raise a number of complexities that can threaten to turn a transaction into a proverbial three ring circus.  Many management teams today are experienced, repeat players who have become quite sophisticated with respect to how sponsor to sponsor transactions are structured and how to play buyers and sellers against one another.  Moreover, for middle market companies, management represents a particularly valuable form of “human capital.”  In this volatile mix, advance planning and close engagement with the sale process are critical ingredients for achieving success.

_{[i]  For ease of reference, this article uses the terms “reinvestment” and “rollover” interchangeably.  However, in actual usage, the terms have different connotations: “reinvestment” implies a transaction where management uses after-tax proceeds to purchase equity securities of the purchasing entity; “rollover” implies a transaction where management exchanges existing equity securities for equity securities of the purchasing entity on a pre-tax or tax-deferred basis.}