After four years in the doldrums there finally appears to be some wind in the sails of the IPO market. Louise Cowley considers the relationship between VCs and fund managers and asks, ‘how private equity-backed offerings will fare in 2004?’
As the New Year gets underway, a buzz of optimism surrounds private equity investors’ discussions about the public markets. Hopes are high that the long-promised market revival is on the way, providing buyout houses with the opportunity to give their portfolios a thorough airing. There has already been much speculation about which IPOs will get away but ultimately their success or failure relies on demand from institutional investors.
Despite the steady improvement of market conditions in 2003, the flood of European IPOs predicted by the more optimistic commentators has yet to be seen. But activity did pick up in Q4 2003, with PricewaterhouseCoopers reporting 67 IPOs across Europe, and prospects for 2004 look good so far. Neil Austin, head of new issues at KPMG Corporate Finance, says: “A rising market over the last nine months and the availability of funds provides a platform for renewed confidence as we enter 2004. We are seeing more companies starting their preparations; something no one was willing to do a year ago.”
As the unfulfilled promise of previous IPO recoveries has proved, more than just optimism is needed for companies to go public. Last year the message was that only companies with a significant market capitalisation would appeal. In 2003 buyout firms Apax Partners and Hicks, Muse and Tate were the beneficiaries of London’s largest IPO, the £1.226bn floatation of Yell. Although eventually oversubscribed, even this listing did not get away on the initial attempt.
The feeling this year is that there will also be a rally for good quality small- and mid-cap companies. Speaking at December’s Investec Private Equity Forum, Andy Brough, manager of the Schroder UK Mid 250 Fund, said he was seeing an increased demand in this area of the market. Gervais Williams is head of UK smaller companies and a senior investment manager at Gartmore. He says: “The smaller end of the market, £10m to £15m new issues, is very vibrant. VCTs have helped with demand in this area as many invest in AIM-listed companies and this has supported these new issues.”
Tax and regulatory changes to the conditions of AIM listings mean the junior market is attracting more IPOs, as well as listings from public companies outside the FTSE250. Commenting on PricewaterhouseCoopers’ latest quarterly IPO Watch Europe survey, Tom Troubridge, head of the firm’s London capital markets group, said: “AIM continues its strong performance, boosted by the uptake of the new fast track admissions process. We have also seen some innovative use of the smaller companies market. Offers to acquire Center Parcs and Northumbrian Water have been financed through AIM, taking advantage of the relatively quick admissions process, with the strategy of moving on into the main market at a later date.”
The list of potential flotations for 2004 is varied, with new additions on an almost daily basis, but what type of companies are institutional investors, the main target market for these offerings, actually hoping to see brought to the market?
With the IPO window having been more or less shut for several years it’s unlikely that private equity investors are the only ones looking to take advantage of this potential opening. Private equity-backed companies will be competing for institutional money against companies de-merging from larger parents and growth businesses that prefer to take their chances on the capital markets rather than accept venture capital.
All of these companies had better hope the scarcity of IPOs in recent years has fuelled demand for new shares, rather than proved there’s no appetite for them. “The indications are that the investor base will be receptive to good quality companies coming to market; the issue is supply and we therefore do not expect to see a flood of new entrants. It is likely that exits by private equity players will drive any upturn in deal volumes over the coming months,” says Austin.
Despite the current feeling of optimism, fund managers are focused on the idea of absolute gains. They are looking for companies that will deliver a return independently of whatever direction an unreliable index might move in. Williams describes three types of stocks mangers look to for absolute returns.
Firstly, companies and sectors with good industry fundamentals; markets where growth is expected and businesses that need capital to support expansion. Secondly, companies where there is a risk that is over-discounted in the share price. However, this doesn’t include companies in danger of going out of business, they must have financial headroom and a good fire sale value. Thirdly, fallen angels, which are under-valued because of a past problem or an uncertain future but that offer upside in recovery.
As companies at IPO rarely fall into the second and third categories and private equity firms in particular aren’t going to bring a company to market in this condition, not all fund managers view VC-backed IPOs as attractive. Investors fear a company’s long-term growth may be sacrificed for the creation of short-term gains for the buyout team and private equity backers. “IPOs in the UK are often preened to near perfection, generally they have a great record for recent years. The market is good at valuing companies and we don’t make money on these companies, except early on when they’re discounted,” says Williams.
Basically, managers are looking for unrealised upside in a company when it lists. For this reason the listing by CVC Capital Partners of William Hill for £950m in 2002 appealed, as deregulation of gaming in the UK meant there was ample opportunity for new investors in the stock to make money. Although a coup for its VC investors, some fund managers believe Yell is less likely to turn a profit for them. The company’s recent, and popular, £721m secondary placing, led by Goldman Sachs and Merrill Lynch, was at an unhelpful discount of just 1.5% on the closing price of the previous day.
Fund managers have levelled other criticisms at private equity firms with regards to the flotation of their portfolio companies. These include ‘optimising’ the performance record of companies to present them in the best possible light and denying external analysts access to the business before the issue. Managers feel the size of issue is sometimes limited to ensure a high price while in the longer term there can be an overhang of sellers post issue.
Fund managers hold advisers at least partly responsible for the mismatch in the expectations of VC sellers and institutional buyers. Some believe advisers have an overly conservative view of what managers’ want from an IPO, in terms of leverage and opportunities for improvement. Institutions are looking for the opportunity to make money too and that often means where there’s some uncertainty to a company. “Corporate financiers assume we only like things that are perfect, but there are no absolute returns from these. They need a better understanding of what we want,” says Williams. “They expect we only want a 30% gearing but it’s not necessarily true. We’re less risk adverse than corporate financiers cast us.”
Despite these criticisms, and the multitude of other stocks that are available to them, fund managers are predicted to lap up new private equity-backed offerings in 2004. While multiple issues in well-populated sectors have little appeal to institutions, IPOs are attractive if they offer access to new trends in industry sectors that are in contrast to the existing stocks held by managers. Other appeals include the opportunity for funds to invest a significant amount in a new stock.
Managers could also benefit from new trends in the IPO market, such as the ‘hostile IPOs’ achieved by Collins Stewart. This comparatively small operation won the auctions for Northumbrian Water and Center Parcs, which it acquired from private equity owners MidOcean Partners, and then floated them immediately on AIM. Williams believes deals such as these could offer managers more upside than if the companies were bought to market directly by their VC backers, as a shorter run up to a flotation can mean there’s a greater discount.
Collins Stewart offers a creative exit solution for private equity investors but could also be a threat when it comes to the initial buyouts themselves. The firm is reported to be bidding for the Telegraph newspapers group against private equity firms said to include Candover and 3i, as well as the Barclay brothers, and planning another accelerated IPO.
Fund managers would also like to see changes in the way VCs work with intermediaries. Brough calls for disintermediation of the IPO process, warning too many advisors push prices up and deals often fail because of this greed. Better and more direct co-operation and communication between private equity firms and fund mangers could benefit both parties in an IPO situation.
At the other end of a public company’s life cycle there are more calls for changes in the business relationship between institutions and private equity investors, as the promise of a market recovery threatens to bring the trend for public-to-private (PtP) takeovers to an end.
PtPs of companies such as Fitness First, PizzaExpress and Debenhams ended in bitter battles between private equity bidding groups and institutional shareholders as fund managers grew to resent VCs for stealing companies away too cheaply. Granted, many managers welcomed the opportunity to exit investments through the earlier PtPs of companies that should never have been listed in the first place. However, once institutions put their foot down deals became more difficult and PtP prices escalated, threatening private equity returns.
However, Williams suggests if venture capital firms and fund managers talk directly to each other and work together it’s still possible for them both to profit from these situations. He believes PtPs at the smaller end of the market still offer opportunities. “Funds managers have to be careful as they don’t want VCs to lose interest completely?fund managers have more equities than cash still,” he says.
One of the major changes is that institutions now want to participate in the gearing that gives the private equity firms the extra profits. One solution to this is the partial privatisation or public-to-nearly-private takeover, which lets fund managers retain some upside in a privatisation. (See article about the Cumulative Unsecured Loan Stock (CULS) option being touted as a route to the setting unease of institutional investors involved in PtPs – EVCJ September 2003, p19.)
VCs will no doubt welcome any sign of an IPO recovery but for the time being they must wait and see what reception the first private equity-backed IPOs of the year receive, from fund managers and the markets in general, and whether interest can be sustained. “The opportunities for the success of new issues are limited as they’re going to be constrained by what we have to spend,” says Williams. VCs aren’t going to have an easy ride, and for those hoping to list companies in 2004 more of a partnership with fund managers may be needed. Institutions want to hear from private equity firms and are calling for them to ‘get innovative’. With portfolios to clear, VCs might want to look at what they can do for fund managers as well as what fund managers can do for them.