Floating to the top

While many buyout houses are at a standstill in today's market, several investment banks are at it again as they prepare for the next private equity-backed IPO. In fact, it is now widely known that investment banks are throwing out pitch after pitch in a race to convince their private equity clients to exit their companies through the public markets - but is this really the best route, or is it the only route? What is the driver behind all this talk?

Though we are witness to a gentle recovery in the markets, there are still limited exit options for private companies. "People are becoming more confident that they can sell, and we are seeing a number of deals being completed. On the other hand though, there is still no bank debt available - the syndicated bank market remains firmly shut, notwithstanding government easing. There is a disconnect here," says Adam Levin, partner at international law firm Dechert.

He continues: "The exit options available to the private equity sector are either some leveraged type of recapitalisation via the high-yield market or the IPO route."

As a result, many advisers have leaned towards the public markets, especially since the recent rally in stocks. Indeed, some high-profile buyout shops have come to the fore lately, announcing that they are prepping their companies for IPOs. One such shop is none other than Blackstone Group, whose CEO Stephen Schwarzmann, as part of a bold public relations strategy, has flat out predicted that the worst of the downturn is over. He even revealed plans to list as many as eight of the firm's portfolio companies, including UK-based Merlin and United Biscuits. This statement was not just bold, but in complete negation of the firm's stance less than two months earlier.

But it worked: in light of this announcement, Blackstone's shares shot up in the following weeks, as it recently revealed its third quarter profit of $275.3m, compared with a $502.5m loss last year. This is nothing other than a clear-cut sign that optimism in the market is improving.

Blackstone is not the only large-cap buyout house banking on the stock market's resurgence. Bridgepoint has announced plans to exit Pets at Home with a £700m listing, while Hellman & Friedman has revealed its plans to list fund management business Gartmore by the end of the year, seeking to raise a whopping £1.5bn. Permira is another looking to float a number of its portfolio companies in an effort to return cash to its investors. It would prove welcome respite from a tough year that saw the company write down its portfolio by 36% and shrink its fund from EUR11.1bn to EUR9.6bn following a restructing.

The businesses Permira is preparing to float include UK retailer New Look, frozen food maker Birds Eye, Danish telecoms group TDC, and Acromas, the owner of AA roadside recovery and insurance business Saga.

"The public markets are more realistic for this cycle than the last one," says Jacques Callaghan, deputy head of corporate finance advisory firm Hawkpoint Partners. He explains that in the last economic cycle, there were 45 sponsor-backed IPOs in the UK, representing about 10% of private equity UK exits. "I think it will be much higher than 10% this cycle for three reasons - the size of some of the assets that have been bought; the amount of debt loaded onto these companies, making a secondary or tertiary buyout difficult; and the opportunity for a private equity firm to retain a significant stake in the business while raising additional capital to help its company grow," Callaghan explains.

Will they buy it?

IPOs may well benefit the private equity sponsor - if they can in fact pull it off. "Banks are advising managers to the IPO route, as other options are limited. It's a lot of wishful thinking, as IPOs are an expensive and long-term process. It's a high risk strategy - if they don't succeed they might end up with egg on their face," says Levin.

Says one banker: "IPOs are usually a last resort when there is no other exit option. The process is expensive and you must have the right valuations."

Not only are IPOs a "high-risk" strategy, but many cannot help but question whether this signals a return to the heady days of 2005-2007, when an LBO followed by an IPO was a well-trodden route, which often meant sinking the company in a pile of debt in the process.

UK department store Debenhams is an example of a sponsor-backed IPO that led to the company's near collapse. TPG, CVC and Merrill Lynch took the retailer private in 2003, only to re-float the company in 2006, loading the group with heavy debts. Last year, things were uncertain for the retailer, as the prospect of a consumer spending freeze meant that doubt was cast over how the company could ever repay its £1bn of borrowings, which at the time accounted for more than 3x its market capitalisation. This year, the company has managed to revive its balance sheet by slashing its dividends, cutting back on capital expenditure, launching new brands and, finally, through a £323m capital raising, all of which took place without the help of its private equity backers who all exited the business in the last year.

One analyst recently told unquote" that, while such exits can produce an attractive return for investors, they often do not result in any substantial quantity of debt being removed from the target's balance sheet. Given the high levels of debt in many of these deals, the businesses will still need to refinance their debt before loans mature.

Ian Moore, partner at law firm Norton Rose, says that there is a "wall of maturity" looming between 2012-2014, when approximately $430bn of leveraged loans is due to mature. Businesses will remain under enormous pressure in the next few years.

In addition to this, while an IPO will mean an exit for the private equity firm, the management of the company almost never sells its shares. They are typically locked up for a significant period of time because, if they were to sell, this could easily have a negative effect on the stock price.

"For the management of these companies, the IPO is just the beginning. Once the company is on the public market, it is obliged to report quarterly and is subjected to greater regulation and also to the pressure that the capital market brings with it. It is much more demanding than the private sector because management can often find that the valuation of its company is affected by factors completely outside its control," explains David Baylis, partner at Norton Rose.

Nevertheless, the IPO market seems to be re-opening, which could lead to the listing of many companies that do not have sufficient market capitalisation. "If we look back, we see companies that arguably should not have gone to the public markets. In some cases there is simply no market to trade their stock," says Moore.

Still, Levin believes that the pipeline for IPOs will reach its conclusion by the middle or end of next year. "If the rally in the markets still exists, we will see a slew of deals in front of the market at once. If there is a pause in the rally or a reversal, it is anybody's guess what will happen. If there is no investor appetite for IPOs, we could be back to where we started," he insists.

Fundraising flurry

From a private equity firm's perspective, exits are invariably a fundraising consideration, as the sale of portfolio companies will return some cash back to LPs, which may well help GPs raise money for their next fund.

Investment manager at Hermes Private Equity, Lynsey Register, says that she prefers not to see buyout GPs falling in love with their investments: "Especially for those early realisations in a fund, we would rather see an exit at a reasonable multiple to get capital back to investors than hold out for eight-plus years in the hope of the big win, as you never know what is around the corner."

And some managers are having a definite effect on their LPs as a direct result of their exit plans. The best example of this is Blackstone. Last month, it was reported that investors in Blackstone's sixth fund, Blackstone Capital Partners VI, were looking to increase the size of their commitments to the vehicle, which launched in January 2008. It is understood that Blackstone has raised about $10bn for BCP VI so far, half of its original target, yet closer to its revised goal of between $12-$15bn.

"I suspect that some LPs are now saying that they will only invest in a new fund out of cash realised from the GP's existing fund, increasing the pressure on GPs to exit their portfolio companies," says Baylis.

He adds: "Many of these recent IPO announcements are a way of putting investee companies in play and in particular to make trade buyers take notice. The certainty of a trade sale or secondary buyout over an IPO is much more attractive to most GPs and the aim will be to sell the investee company before it comes to market."

We've already seen signs of this beginning in the market, as this unquote" issue alone clocked up nine exits, all but one of which are trade sales.

If, however, debt markets do not return in a timely fashion, and deal activity does not in fact recover to its previous levels of glory, IPOs may well take off, which could lead to new money in the markets and thus, an improved and growing economy.

"The risks are greater when things are stale than when they are moving up. If growth comes back, banks will feel more confident about obtaining a higher return and start risking capital. We are all hoping that this will happen," says Levin.

Although IPOs may not be the best route for all involved, they certainly go some way towards restoring confidence in the market, and perhaps that, now more than ever, is what is most necessary for private equity to succeed.

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