As private equity (PE) firms and financial sponsors of all varieties look for ways to generate liquidity in today's economic climate, partial exits are becoming a tool that some firms leverage to provide returns to investors. PitchBook reports on several recent examples of partial exits by firms across various sectors, noting that these are not necessarily a bad thing, just a sign of the current climate. With firms beginning to utilize this option more frequently, below we look at the issues to consider when weighing a partial exit.
What are the Reasons for a Partial Exit?
In a partial exit, the sponsor sells a portion of their stake in a portfolio company while maintaining exposure to the company. This could mean selling shares to another sponsor (such as another firm or institutional investor), or if the company is public, it might mean a secondary offering (could be in the form of a brokered sale, block sale, block trade, shelf takedown or even a private placement). These allow firms to see a return on their investment yet still participate in the potential for upside in the future.
There are several reasons why a firm might choose to do a partial exit instead of waiting for the exit event, including pressures from investors to generate liquidity. Firms have been holding onto their portfolio companies for extended periods since the end of the "zero interest rate" environment, which can lead to pressure from their investors. Bain & Company's Private Equity Mid-Year Report states, "While exits also appear to have arrested their freefall, activity has landed at a very low level. And as limited partners (LPs) wait for distributions to pick up, most funds are still struggling to raise fresh capital." A partial exit provides immediate liquidity that can be utilized to either invest in new opportunities or return capital to investors, helping manage the fund's lifecycle.
There can also be a highly strategic component to a partial exit depending on who purchases an interest in the asset. A strategic investor can often bring in new expertise, resources, or access to new markets that can aid in the company's growth. Suppose the investor brings complementary strengths to the partnership. In that case, it can also guide the company's direction, positioning the company for the kind of growth that can lead to an exit at a much higher valuation down the road.
Finally, a partial exit provides a valuable mark to the portfolio's valuation for the general partners and their marketing to new and existing LPs for the next fund.
What are the Specific Challenges to Consider?
As with any exit event, there are specific challenges that firms must consider when looking at a partial exit.
First, there should be an alignment of interests between the firm and the incoming investor so that there is a clear strategic vision for the portfolio company that can be executed by the existing management team. The balance of control and decision-making authority between the partially exiting sponsor and the new investor can introduce additional complexities, such as allocating board seats and apportioning fair voting rights for both parties involved. The deal structure is critical, as it must accommodate the interests of the partially exiting sponsor and the incoming investor. In these situations, determining earnouts, preferred returns, and other financial issues can come with a higher level of complexity.
There are also legal and regulatory considerations, such as securities laws and disclosure requirements, not to mention the possibility that a partial exit could trigger additional regulatory scrutiny or approval requirements. Contractual obligations must also be scrutinized to ensure the exit does not violate any shareholder agreements that could include the right of first refusal or drag-along rights. If there is going to be a significant change in ownership with the exit, board approvals could be required, and there could be a need for an adjustment in voting rights and board representation based on the goals of the new investor.
Partial exits can offer financial sponsors the opportunity to balance the need for immediate liquidity and risk management while still maintaining the potential for future gains down the road. It can provide flexibility as a valuable tool that allows for maximized returns and the development and growth of the portfolio company. A successful partial exit requires careful planning and coordination with legal counsel to ensure it is fully compliant with all regulations and to consider the interests of all parties involved.
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.