IPOs way forward for LBO funds

Leveraged buyout (LBO) funds have been criticised for their focus on maximising short-term returns. Much has been said about how much value they capture and how little is left when they exit a business in an initial public offering (IPO). These concerns have resulted in much public debate and many equity investors are wary.

However, a study analysing the long-term stock returns of LBO-backed IPOs in the UK shows that these concerns are invalid. The analysis was commissioned by Terra Firma, backed by Citi and carried out at London Business School. A companion paper was also produced for Germany and backed by Deutsche Bank.

The UK report finds that a strategy of investing an equal share in every IPO backed by an LBO fund over the last 17 years, would have beaten the market markedly and produced 3.3 times the return of the FT All Share Index. An equivalent strategy for non-LBO-backed new issues would have outperformed the market by only 9% over the period. This is evidence that buyout firms create long-term shareholder value.

Some market observers have complained that LBO funds often put too much debt on their companies, extract too much cash and push them too rapidly into an IPO without adding much long-term value to the business. The analysis finds no evidence that the level of debt has any significant impact on the long-term stock price performance. But the study shows that size matters, stake matters, and time matters. The higher the fund’s assets under management, the bigger the IPO returns. The greater the equity stake of the LBO fund in the company after the flotation, the better the returns. And the longer the fund’s involvement with the firm before the IPO, the better the new issue performs.

Companies backed by buyout organisations represent an increasing share of IPOs. Since 2004, LBO-backed new issues accounted for almost 10% of the total number and about 30% of the volume of all IPOs in the UK. Therefore, the positive long-term performance of LBO-backed IPOs has significant wealth implications for equity investors and the economy.

The analysis covers 128 leveraged buyout-backed IPOs, listed in the UK between 1990 and 2006, and compared their performance to a control group of 1,121 non-LBO-backed IPOs on several measures of long-term stock return.

The German companion study covers 138 private equity-backed IPOs (33 LBO and 105 venture capital-backed) and 383 non-private equity-backed new issues. The German findings are similar to the UK’s: LBO-backed new issues consistently outperform market indices over the first three years after the IPO. Buyout-backed IPOs also beat non-private equity flotations on most measures. A portfolio strategy investing in every LBO-backed IPO produced an average annual return of 12.1%, beating market indices in six of the last nine years, and outperformed the CDAX Index by a factor of 3.05.