Private equity IPOs: making hay while the sun shines

GPs are eagerly taking advantage of the return of flotations as an exit route. But what is driving market appetite, and is the industry in danger of slipping back into old and undesirable habits?

Last year there were more than 40 private equity- and venture capital-backed IPOs across Europe, according to unquote" data. A further 19 have already taken place in the first quarter of this year, including EQT and Goldman Sachs' €4bn IPO of ISS in March and Warburg Pincus's ￡750m flotation of Poundland in February (resulting in a 4.5x money multiple for Warburg on the partial sale of its stake).

The reopening of the IPO window in Europe hinges on the renewed hunt for yield by institutional investors. While interest rates remain low, investors are turning their backs on safe-haven assets that provided shelter while the economy began its recovery and are now rediscovering an appetite for riskier investments.

The wave of sponsor-backed IPOs could be reaching overload

ECI capitalised on this hunger in the IPO of Bargain Booze, which achieved a market cap of ￡66.7m when it listed on AIM at the London Stock Exchange (LSE) in July last year. Investors were told of a yearly 8% dividend of ￡5.2m, dependant on company performance. "That makes it one of the highest yielding AIM stocks," says ECI partner John Hayhurst (pictured). "Ultimately, the investors are taking an equity risk, but the track record of cash generation in the business is fantastic. Even if the business underperforms, paying a ￡5.2m dividend is within its capability. The EBITDA to cash conversion of Bargain Booze is a key strength."

ECI netted a 4.5x return from Bargain Booze through the full sale of its 75% stake, foreshadowing the mounting evidence that the stock exchange can often offer the best valuations for assets in today's environment.

The public market is indeed awash with cash for the first time in years. Aside from Vodafone's sale of Verizon, which returned ￡15.9bn of special dividends to shareholders in Q1 this year, corporate balance sheets across the board are becoming stronger and money is pouring out of emerging countries back into developed markets. As well as this, the inflows of institutional investors themselves are increasing as confidence in public equities returns.

Europe's private equity industry has wasted no time in taking advantage of this new paradigm. The first wave of private equity-backed IPOs has performed well, with several backers exiting completely at the time of listing. Indeed, Arle Capital Partners achieved a 2x multiple on its full exit from logistics and parcel distribution company DX Group, which listed on the LSE with a market cap of ￡200m in February. "An IPO was not initially the most obvious route," says Arle investment director Raphael Candelier, "but when we started to talk to some advisers, it became a more credible option. The Royal Mail IPO confirmed our thoughts that listing such a business was possible."

Stock-picking niggles
Sentiment remains mixed over whether institutional investors are still wary of private equity assets coming to market, with some industry commentators believing the current wall of money may be causing tunnel vision on the public market; investors are voraciously searching for yield, which could mean they disregard other important factors when stock-picking.

Concerns are also being raised by institutions themselves over fellow investors and the lack of due diligence carried out prior to investing in IPOs. However, Jacques Callaghan, deputy head of European investment banking at Canaccord Genuity, argues the increased volume of potential candidates has meant investors are being highly selective. "The market is more discerning about which ones they want to meet and participate in," he says. "After the beginning of 2010, one of the things that a number of institutional shareholders were very vocal about was changing the IPO process. They wanted to ensure that they had earlier and better access to potential IPO candidates."

While the first wave of private equity-backed assets that recently came to market had spent a fair amount of time preparing for flotation, it seems this preparation period is decreasing rapidly. "It's very evident that the window for IPOs is wide open and history has taught us that those windows do not typically stay open for very long, so people are now running very hard," says Michael Abraham, head of the EMEA financial sponsors group at UBS.

The efforts appear to be paying off, with appetite for private equity-backed IPOs clearly increasing. This could be down to a combination of the quality of the companies coming to market so far and, interestingly, an increase in the stake size sold by a private equity backer at IPO.

"Even some of the most vociferous institutional shareholders that had no interest in buying from private equity in 2010 are now participating in private equity-backed IPOs," says Canaccord's Callaghan, who points out that the average sell-down on an IPO by a private equity firm has gone up to around 55% in recent months, compared with 40% from the previous decade. "For the right company and management team, institutional shareholders are more comfortable in buying more from private equity, because it means there is greater liquidity and less stock overhang."

ECI was able to capitalise on this as early as the first half of last year, when the IPO craze had not yet fully taken hold. "On many IPOs, the institutions want the private equity houses to remain, simply because it shows commitment to the float," says Hayhurst. "But there was a clear reason why we were after an exit and institutions were happy to allow us to get out on that basis. We had been in the business for seven-and-a-half years, so it was not as though we were doing a fly-by-night operation where we had owned it for two and were keen to get out."

However, sell-down at IPO is certainly a delicate act. Other industry professionals believe investors are becoming more comfortable with private equity-backed IPOs because of the size of stakes retained at flotation, which translates into a greater alignment of interest. "Private equity houses seem to be taking a fairly balanced view on the extent to which they need to exit now," says Mark Langford, a partner at McGuireWoods. "You've also got management participating in the IPOs and it gives institutions a lot of confidence when both the private equity houses and the management have skin in the game."

Forgotten but not forgiven
But, while some industry players are convinced that - for the time being at least - all has been forgiven and forgotten, others maintain past mistakes by the asset class may come back to haunt GPs now taking assets public. "The market may have forgotten, but it will not take very much to remind people," says Patrick Groarke, partner at corporate finance firm Livingstone Partners.

LPs are also keenly aware of potential apprehension from institutional investors: "There is always a concern on the part of institutional shareholders about why private equity is seeking to sell and, accordingly, the market is sensitive to any disappointments from private equity-backed companies," says Peter McKellar, senior managing partner at SL Capital Partners. "Institutional shareholders are naturally sceptical as to why private equity is selling."

These concerns mainly stem from the modus operandi of private equity, which institutional investors view as aggressive running of a business for shorter-term returns. "If you look at the track record of IPOs that come out of private equity in terms of performance, it is not unusual sometime down the road to find either an issue where they have to increase investment in the business, or we find out that costs have been cut very aggressively in the period of ownership," says David Moss, head of European equities at F&C Asset Management. "We do not want to take these businesses off owners' hands when we do not know what has been going on in the meantime. And while that is a problem with IPOs in general, it is exacerbated by private equity ownership."

Furthermore, some industry players surmise that GPs could be tempted to push their luck given how frothy the market currently is. "A lot of the private equity-backed companies that have floated are good quality businesses, but inevitably there will be businesses that come onto the market that underperform," says Groarke. "If investors see some of these businesses underperforming, this is where things start going a bit pear-shaped and it becomes a struggle to get other private equity-backed companies onto the market."

This concern is underpinned by the assets that have already floated and are performing disappointingly in the aftermarket. Since selling its shares for 260 pence apiece at IPO and achieving a ￡1.46bn market cap – equivalent to 100x EBITDA – venture capital-backed Just-Eat has stayed firmly below its initial offer price since its flotation in April.

Some market commentators are labelling the current price levels achieved at flotation as a bout of "momentum investing". Says UBS's Abraham: "Public equity valuations are pricing in further European recovery that we have not yet seen, so it remains to be seen if performance will live up to the expectation that investors have effectively already priced into the stocks."

Tackling the overhang
Concerns have also arisen over the backlog of mega-deals from the 2006-07 period. Having sat under private equity ownership through the harsh recession, the backers of these companies now desperately need to return cash to investors. However, the size of these boom-time assets – which have been called "unexitables" by industry players – means a trade sale or secondary buyout is often tough to get across the finish line. "IPOs are the least preferred option [for LPs], but they are necessary to remove the overhang of deals that were done in the 2006-07 period," says SL Capital's McKellar, "particularly the very large ones where there is no obvious exit route either to trade or another private equity sponsor. It was a concern even when many of these deals were done that an IPO would probably be the only exit route available."

"The public market has been willing to buy private equity-backed businesses that the private equity community is not willing to buy," says Duncan Johnson, head of the unquoted pool at Caledonia Investments. "That is quite interesting, as you would normally say that the private equity market has a higher risk appetite than the quoted market."

However, the unnaturally long periods of ownership under private equity could work in the favour of these companies by addressing one of the main black marks associated with private equity-backed IPOs: "There's a difference from the mid-2000s, where some private equity houses were offloading portfolio companies onto the market that were massively leveraged," says Jonathan King, a partner at Osborne Clarke. "Those we are seeing at the moment do not tend to be anywhere near that. In fact, some of the ones we are working on have no debt or are eliminating debt as part of the IPO, so they are going to the market debt-free."

Pulling down the shutters
While any number of occurrences could close the window of opportunity, the general consensus is that the anticipated rise in interest rates will take the edge off institutional investor appetite for riskier investments. But the possibility of overexuberance on the part of private equity firms when listing portfolio companies could also factor into a market cool down. "If we reach a situation where these IPOs get too tightly priced and aftermarket performance starts to deteriorate more broadly, then appetite for new issues will decrease," says Abraham. "But that is not something we are foreseeing in the near future."

The onus will still be on private equity firms not to abuse today's incredibly favourable market conditions, though.

"Private equity houses and bankers are very conscious of not doing something that closes the market," says David Vaughan, IPO leader for UK and Ireland at EY. "Nobody wants to be where we were in 2008-10. Having open and functioning equity markets is in everybody's interest and people are genuinely trying to make sure they do not make the same mistakes that were made in late 2006-07."

The momentum still appears strong, with a pipeline of private equity-backed IPOs expected on the other side of the summer. But the recent cancellation of Bridgepoint-backed Fat Face's IPO – reportedly stemming from waning interest for retail IPOs in London – will serve as a reminder that GPs had better make hay while the sun shines.

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