Ready, Set, Exit: Private Equity Exit Strategies

Introduction

Private Equity (PE) firms are known for their ability to generate significant returns through strategic investments in private companies. These firms operate PE funds on behalf of institutional investors and high net-worth individuals (HNI) and then allocate the funds to selected portfolio (investee) companies. Beyond funding, PE investors actively implement operational and strategic changes in these portfolio companies to enhance their value.

Typically, PE funds operate with a finite term, usually between 10 to 12 years, and are structured into distinct stages. These include the fundraising phase, the investment period, the management period, and finally, the exit phase, where investments are sold off, and returns are distributed to the investors.¹ While much attention is often given to the initial stages of the investment process, the importance of a well-crafted exit strategy cannot be overstated. Experienced investors recognize that the true measure of an investment's success is determined by the quality and execution of the exit strategy, which ultimately drives the returns.

Understanding Strategic Exit Planning

PE investors typically sell their equity stake or assets in an investee company after a defined holding period. A successful exit strategy details how the investor plans to liquidate their investment and realize returns while minimizing risks. Choosing the right exit strategy requires evaluating legal implications, requirements of each option, market conditions, and the investor's goals to determine the most effective exit route.

Key Considerations in Exit Planning

1. Timing of Exit: The timing of an exit is crucial, as it hinges on market conditions, economic trends, and industry developments that directly influence a company's valuation and its appeal to potential buyers.
2. Performance of Portfolio Company: The company's financial health and operational efficiency are critical in driving its valuation. Strong performance metrics enhance its attractiveness and enable it to command a premium price, appealing to a wider range of buyers.
3. Identifying Potential Buyers: Defining a diverse buyer universe, including strategic, financial, and industry-specific investors, enhances the likelihood of a strategic match and favorable valuation.
4. Regulatory Environment: Addressing legal and regulatory issues proactively is essential to facilitate a smoother, quicker exit process.
5. Exit Readiness: This involves comprehensive preparation to ensure the company is ready for potential buyer scrutiny. This includes having detailed financial statements, efficient operations, and a strong management team in place.

Exploring Exit Routes

There are various exit routes available to a PE Investor seeking to exit an investment, including:

• Initial Public Offering (IPO): Here, the investee company's shares are listed on the stock market for the first time for public subscription. This route provides a significant opportunity for the PE investor to sell its shares to the public and exit with substantial returns on its investments. For example, Hilton Worldwide's 2013 IPO generated substantial profits for investors like Blackstone.²
• Secondary Sale: In a secondary sale, a portion or all the investee company's shares are sold to another PE investor or institutional buyer. This strategy offers flexibility and allows the PE investor to monetize its investment while retaining some level of involvement or control.
• Strategic Acquisition/Sale: This strategy involves selling the company to a strategic buyer, often a competitor or a company in a related industry. For instance, Under Armour's acquisition of MyFitnessPal in 2015 expanded its market reach and provided a profitable exit for MyFitnessPal's investors.³ Another example of this exit strategy occurred in 2011 when Bain Capital exited LinkedIn. Bain Capital executed a strategic exit from LinkedIn by selling its entire stake of over 6.7 million shares during a planned equity sale, capitalizing on its early investment in LinkedIn.⁴
• Management Buyout (MBO): An MBO occurs when the existing management team of the investee company acquires the business from its owners, including the PE investors. This can be an attractive option when the management team believes in the company's future and is willing to invest their own resources to take control. For PE investors, this route often ensures continuity and a smoother transition, given the management team's existing familiarity with the company.
• Recapitalization: This involves restructuring the capital structure of the investee company to generate liquidity. This can be achieved through refinancing existing debt, issuing new debt or equity securities, or arranging leveraged buyouts. By restructuring its debt and financial arrangements, the investee company can return capital to its investors while retaining operational control.
• Redeemable Preference Shares: In addition to other exit strategies, PE investors may also hold redeemable preference shares in the investee company. These shares provide investors with the option to redeem them for cash at a predetermined date or upon certain conditions, providing a straightforward exit route. This method ensures that investors can liquidate their holdings and realize returns without the complexities often associated with other exit strategies.

Key Exit Provisions

In Oxbow Carbon & Minerals Holdings, Inc. v. Crestview-Oxbow Acquisition, LLC⁵ , PE firm, Crestview Partners faced significant challenges due to ambiguous exit provisions. This case highlighted the importance of clear and detailed exit provisions in investment agreements.⁶ These provisions not only safeguard the interests of the investors but also facilitate a smooth and strategic divestment process. Key exit provisions to consider include:

• Pre-emptive Rights (Right of First Refusal): Pre-emptive rights⁷ allow existing shareholders to acquire additional shares before they are offered to external investors. These provisions protect investors from dilution of their ownership stakes during subsequent financing rounds, preserving their influence and potential returns.
• Drag-Along Rights (Come-Along Rights): Drag-along rights enable a majority shareholder to sell the company without the obstruction of minority shareholders by compelling all shareholders to participate in the sale. This provision streamlines the exit process as seen in 2016 when Dell acquired EMC Corporation, where these rights prevented minority shareholder opposition, facilitating a unified transaction. ⁸
• Tag-Along Rights (Co-Sale Rights): Tag-along rights protect minority shareholders by allowing them to sell their shares under the same terms and conditions as the majority shareholders during an exit. This ensures equitable treatment and opportunity for profit-sharing. In 2013, Facebook offered to buy Snapchat for $3 billion but the app's founders rejected the offer, believing they could build a more valuable company independently. Some of Snapchat's investors, such as Benchmark and Lightspeed Venture Partner had co-sale rights, allowing them to force the founders to accept the offer. ⁹
• Redemption rights: They provide a predefined exit mechanism by allowing investors to require the company to repurchase their shares after reaching certain milestones. Common in sectors like biotech, these rights offer a clear exit route, ensuring investors can liquidate their stakes once the company achieves specific operational goals.
• Lock-Up Periods: Lock-up periods restrict shareholders from selling their shares for a specified time after an IPO, helping to stabilize the stock price and maintain market confidence. This was seen in LinkedIn's IPO, where Greylock Partners' investment was subject to a lock-up period. This restriction ensured market stability and allowed LinkedIn to maintain its valuation post-IPO before Greylock Partners could sell its shares.¹⁰
• Exit Triggers: Exit triggers are specific events or conditions that enable shareholders to initiate an exit or liquidity event. These can be time-bound, linked to financial milestones, or related to changes in company control, offering shareholders timely opportunities to liquidate or adjust their investments based on predefined scenarios. 
• Board Representation: These provisions allow investors to participate directly in the governance and strategic decision-making processes. This was seen where Greylock Partners secured board representation in LinkedIn, enabling them to influence key decisions leading up to LinkedIn's successful IPO and acquisition by Microsoft. ¹¹
• Liquidation Preferences: These provisions protect investors by ensuring they recover their investment before common shareholders in exit scenarios like sales or mergers. These often include multipliers like 1x or 2x; a 1x preference ensures preferred shareholders are paid an amount equal to their original investment before common shareholders, while a 2x preference doubles that amount. This can significantly influence negotiations, giving investors with substantial preferences greater leverage to dictate terms. Liquidation preferences provide a structured and prioritized exit pathway that aligns with investor risk profiles and ensures recovery of investments.

By including these provisions in investment agreements, PE investors can safeguard their interests and facilitate a smoother and more profitable exit process.

Leveraging Market Dynamics for Strategic Exits in Nigeria

Economic conditions and sector-specific dynamics influence PE exit strategies. In sectors such as technology, where rapid innovation prevails, IPOs and strategic sales are often favored due to high growth potential. Conversely, the asset-heavy and stable manufacturing sector typically leans toward recapitalizations and management buyouts to ensure continuity under experienced management.

Economic booms increase market valuations and boost investor confidence, making IPOs and strategic acquisitions more appealing. During downturns, however, the focus shifts towards preserving value; strategies like recapitalizations or secondary sales become essential to provide liquidity and maintain stability.¹² Within the Nigerian market, it is crucial for PE investors to adapt their exit strategies to these fluctuating economic realities and regulatory changes to achieve successful and profitable exits.

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Footnotes

1. For more information on how PE operates, see our previous article on 'The Private Equity Advantage: Ready, Set, Grow' at: https://www.mondaq.com/nigeria/shareholders/1482750/the-private-equity-advantage-ready-set-gro

2. University of Oxford, Saïd Business School, 'Hilton Worldwide: Preparing for International Expansion' (University of Oxford, Saïd Business School, Working Paper Series, 2018) https://www.sbs.ox.ac.uk/sites/default/files/2018-07/hilton-new-watermark.pdf.

3. Under Armour, 'Under Armour Acquires Endomondo and MyFitnessPal to Establish World's Largest Digital Health and Fitness Community' (Under Armour, Press Release, 4 February 2015) http://investor.underarmour.com/news-releases/news-release-details/under-armour-acquires-endomondo-and-myfitnesspal-establish

4. LinkedIn: Bain Capital Cashes Out' Financial News (London, 16 November 2011) https://www.fnlondon.com/articles/linkedin-bain-cashes-out-20111116.

5. No. 536, 2018, 2019 WL 237360 (Del. Jan. 17, 2019),

6. https://corpgov.law.harvard.edu/2019/02/09/good-faith-fair-dealing-and-exit-provisions/

7. This is similar to the provision of Section 141, Companies and Allied Matters Act 2020.

8. Ron Miller, '$67 Billion Dell-EMC Deal Becomes Official Today' (TechCrunch, 7 September 2016) https://techcrunch.com/2016/09/07/67-billion-dell-emc-deal-becomes-official-today/

9. FasterCapital, 'Co-sale Rights: How do they Work and how do they Affect Equity Dilution and Liquidity for Startup Investors and Founders?' (FasterCapital, 20 March 2023) https://fastercapital.com/content/Co-sale-rights--How-do-they-work-and-how-do-they-affect-equity-dilution-and-liquidity-for-startup-investors-and-founders.html

10. Scott Murray, 'LinkedIn Lock-Up Period Expires Monday: Buy Puts' (Seeking Alpha, 18 November 2011) https://seekingalpha.com/article/308720-linkedin-lock-up-period-expires-monday-buy-puts

11. Douglas MacMillan, 'LinkedIn Share Sale May Be First in Wave of Social Media IPOs' (Bloomberg, 28 January 2011) https://www.bloomberg.com/news/articles/2011-01-28/linkedin-share-sale-may-be-first-in-wave-of-social-media-ipos

12. Bookmark Partners, 'A Strategic Guide to Exit Strategies in Private Equity' (Bookmark Partners, 11 November 2023) https://www.bookmarkpartners.com/post/a-strategic-guide-to-exit-strategies-in-private-equity

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.