Alternative Exit Routes in Private Equity

An investment exit option is a fundamental consideration for most investors in private equity firms. It helps them factor their assessment of the exit outcome into their analysis of target and expected internal rate of return.

Initial Public Offering (IPO)

This occurs when a firm’s equity is offered to the public through a sale. An IPO generally results in the highest exit value due to improved liquidity, better access to capital, and the potential to recruit more qualified managers. IPOs tend to be less flexible, expensive, and tedious than the other alternatives.

IPOs are best suited for firms with strong growth projections and substantial operation history and size. The timing of an IPO is critical.

Secondary Market

In this case, the firm is sold to an alternate investor or firm interested in acquiring strategic motives. A good example would be a firm in the same business that wishes to expand its market share.

Secondary market sales between investors are pretty predominant in cases involving buyouts. Venture capital portfolio firms are occasionally exited via a buyout to another firm. Note, however, that venture capital firms are usually at the development stage and, as such, cannot support large debts. Secondary market sales result in the second-highest company valuations after IPOs.

Management Buyouts (MBO)

Here, the management takes over the company. Even then, the management must have the financial capacity to finance the acquisition. Although the management will strongly guarantee a firm’s ensuing success, the resulting high leverage may limit the management’s flexibility.

Liquidation

Under liquidation, the complete sale of a firm’s assets is pursued when the firm is no longer profitable and is a going concern.

Upon liquidation, it is imperative to appreciate the potential for negative publicity that may emanate from disgruntled displaced employees. Further, there is a possibility of failure by the firm to achieve its objectives.

Timing an Exit

Exit timing is also key to firm value. Indeed, a private equity firm should be flexible. A portfolio firm, for instance, may not be disposed of due to poor capital markets. In that case, the private equity firm may want to consider acquiring another portfolio firm at a low price. The private equity firm may then forge a merger with the firm it has acquired and wait until capital market conditions improve. The firm may then sell both portfolio firms as one entity.

Question

Amanda Jones works for Orange PE firm, which is analyzing a target company. Jones has been asked to select an exit route with a high exit valuation, most flexibility, besides being inexpensive. Which of the following is the best exit route that Jones can choose from?

1. An IPO.
2. A liquidation.
3. A secondary market sale.

Solution

The correct answer is C.

Secondary market offers the second-highest valuation after IPOs with more flexibility and cost.

A is incorrect.  IPOs have the highest valuation, but the high cost and lack of flexibility deter many PE firms from choosing it as an exit route.

B is incorrect. In liquidation, a firm’s assets are sold once it is established that they are no longer profitable.

Reading 38: Private Equity Investments

LOS 38 (e) Explain alternative exit routes in private equity and their impact on value.