Friday Letter: Mind that float

For private equity firms, exits via IPO can be great. A successful floatation of a portfolio company at an attractive valuation will get the champagne corks popping, especially if the share price climbs in the aftermarket.  

In this case, not only does the equity sponsor achieve or surpass the targeted return: a pleasing halo will gather around its name as well. A general partner giving the public market a well-run business with upside potential at the right time will likely see the value of its own brand multiply.

However, IPO exits also come with serious potential downside. For a start, they rarely allow the private equity firm to complete a full exit, as public market investors insist that the previous owner keep some skin in the game. Exit planning thus becomes more complicated and protracted, as portions of retained shares need to be drip-fed into the market at a pace that doesn’t undermine the share price and at a time when the returns are still right. Alternatively, managers can pass stock onto the limited partners in their underlying fund by way of in-kind distributions. But many LPs don’t want the administrative hassle that such distributions entail, and many would much rather get back from a fund what they committed in the first place, i.e. cash.

It is also true that a portfolio business will likely fetch a higher price if it is sold to a trade buyer instead of going public. A strategic investor acquiring a private equity-sponsored asset tends to have lower return requirements than the public market, and it will see synergies that to an equity investor will be meaningless. As a result, a trade sale will often result in a better return to the GP, and as far as liquidity events go, will practically always beat the IPO in terms of immediacy and cleanliness of exit.

Then, and perhaps most importantly, there is the fact that the aforementioned halo effect can absolutely work both ways. This week’s revelation of serious accounting irregularities at Refco, the US broker floated by buyout giant Thomas H Lee earlier this year, is a reminder that from the point of view of financial sponsors, an IPO can be a short road to a bad place. There is no suggestion that TH Lee might be directly responsible for the problems allegedly caused by Refco’s former chief exec. Still, questions have been asked about how the firm’s due diligence could have failed to uncover the alleged $430 million issue in the company’s books.   

TH Lee is one of the biggest names in the private equity business, and its standing with investors and partners is such that long-term reputational damage is not to be expected. Neither does the firm stand to lose any money on its investment in Refco, limited partners in the relevant fund say, despite the fact that it holds a still meaningful amount of shares in the company.

However, the broader point is that if a formerly private equity backed company gets into any sort of trouble post IPO, be it accounting-related or otherwise, a wide debate as to who is to blame – the company and its management or the equity sponsor that took it to market – is bound to ensue. It’s the sort of brouhaha that general partners can do without, especially because in the current market environment, neither journalists nor the general public are particularly prone to giving private equity firms the benefit of the doubt.  

Therein lies perhaps the biggest risk for GPs in taking portfolio companies public – you may (rightly) think that you’ve done your job and that you’ve done it well, you’ve sold the business on – then problems discovered post exit return to haunt you unexpectedly. 

Today, the IPO window is opening wider. At the same time, corporate buyers are rediscovering their appetite for M&A. In light of the potential public market pitfalls, it should come as no surprise that private equity fund managers in exit mode tend to be more excited about the latter trend.