Improving Cash-on-Cash Returns

Limited partners in private equity funds can be a skeptical group when it comes to unrealized returns. And that can be a problem for the many general partners looking to come back in 2011 to replenish their war chests.

The increased focus on cash-on-cash returns became apparent to me at the annual meeting of a well-known growth equity fund. One of the fund’s star portfolio companies presented a detailed account of how it had grown revenue and EBITDA in a very difficult economy. The fund had already distributed roughly half of its cost basis in the investment and had written up the value of the company by threefold. During cocktails, while speaking with the representative from a mid-sized college endowment invested in the fund, I remarked that the company was still quite conservatively valued. The LP responded, “I’ll believe the valuation when I see the exit.”

But while cash distributions are the ultimate goal of any fund, an over-emphasis on realizations can sometimes lead to premature exits. This can be especially heartbreaking when the company is at an inflection point such as the implementation of management changes, a financial restructuring or a major pending transaction.

As an alternative to selling full ownership in a portfolio company, fund managers should consider selling minority interests in one or more of their best portfolio companies to a secondary private equity firm in a direct secondary transaction. Direct secondary transactions can provide a means for secondary funds to deploy capital and general partners to generate cash-on-cash returns and maintain future upside exposure.

Perhaps the best way to illustrate the process and opportunity of a direct secondary sale is to consider a recently exited VCFA Group transaction. In 2008, a fund manager approached us with a dilemma. They had invested in a company several years earlier that had performed well beyond expectations. As a result, they believed the fair value of their investment was nearly ten times its cost. The LPs, while recognizing that the company had performed well, were skeptical of such a dramatic appreciation. Further complicating matters, the company’s GAAP EBITDA understated its profitability due to complex acquisition accounting. Explaining the valuation to existing and future investors was complicated to say the least.

The general partner considered multiple sale options to provide distributions to their LPs, de-risk their portfolio and validate their valuation. The fund was hesitant to sell one of their best companies at what they believed to be an inflection point. Moreover, strategic buyers had difficulty dealing with the complex accounting, leaving a sponsor-to-sponsor transaction as the likely outcome. The GP believed that the company could be restructured in several years in order to reveal its true profitability. Selling to another private equity fund would merely transfer that benefit to another fund.

VCFA and the fund considered a secondary purchase of a minority interest in the company as an alternative to a full sale. After a preliminary indication of interest, we began to diligence both the investment and the manager.

After the diligence had been completed and an agreement on price had been reached, VCFA created a single-investment private equity fund that assumed a minority ownership interest of the fund’s investment. The fund manager continued to control all voting rights related to the interest and was granted a carry incentive to continue to preserve the incentives. VCFA’s cash payment resulted in a distribution to the LPs of the selling fund of a multiple of the total cost of the investment, with the fund maintaining a large percentage of the future upside.

In the months following the direct secondary sale, the company struggled through some acquisition integration issues. Had the fund not been able to execute the direct secondary sale, they might have been pressured for a substantial write-down. Nevertheless, in roughly a year, the manager was able to fix the operational issues and raise additional financing to restructure the company. With the key issues resolved, the company began a sale process with an investment bank. Ultimately, a strategic buyer acquired the company for cash, generating a double-digit multiple return for the fund and an expected 2x return for VCFA.

David Tom works in business development at VCFA Group, a buyer of interests in PE funds on the secondary market. Reach him at dtom@vcfa.com.