Brian Gaynor: Raft of IPOs worth a look - with care

Take out your cheque book and be ready to put pen to paper. A flood of Initial Public Offerings (IPOs), instigated by private equity sellers, is about to hit investors.

Myer is first off the block and will be quickly followed by Kathmandu. If these are successful a raft of IPOs can be expected before Christmas as private equity vendors take advantage of improved sharemarket conditions and investor confidence.

Private equity firms employ the best and the brightest and have the ability to make an ugly duckling look like a gracious swan. The pre-float publicity for Myer, the largest Australian department store operator, and Kathmandu is consistent with this.

Private equity-initiated IPOs are well worth looking at but investors should scrutinise them more carefully than most other IPOs, as illustrated by the Feltex debacle several years ago.

Investors should also bear in mind this insightful story included in Investing the Templeton Way, a book about Sir John Templeton, the founder of the highly successful Templeton Growth Fund.

Peter was a young boy who operated a lemonade stand in his local neighbourhood during his summer holidays. He decided to sell the stand, which generated annual sales of $200.

His friend John offered him $100 and then bragged to his schoolmates that he was going to buy a lemonade operation that would make him a fortune.

The following Saturday John turned up with his $100 but just as he was about to clinch the deal Sam rushed up and offered $110, Mary arrived and bid $125 but David outbid them all with an offer of $150.

Peter couldn't believe his luck but just as he was about to accept David's $150 offer it began to rain and all the bidders disappeared.

John, Sam, Mary and David - we will call them the naive investors - huddled together out of the rain and decided that the lemonade stand was a silly idea and they would make more money selling umbrellas.

Meanwhile Andy, who had been studying these events from a distance, strolled up to Peter and offered him $50 cash on the spot for the stand.

Peter was furious but he finally capitulated because he wanted to sell the stand and Andy's offer, albeit only $50, was the only one available.

Just after Andy completed the deal the naive kids rushed by on their bikes with armfuls of umbrellas and shouted to Andy "You must be some kind of idiot to buy the lemonade stand! What were you thinking?"

The following Saturday was a beautiful hot summer day and Andy did a roaring trade at his lemonade stand while the kids with the umbrellas moped around in despair until they decided that the lemonade business was the best place to be.

Peter offered Andy $100 for the stand, John bid $120 and Mary went to $150 until David piped up with a $200 offer, which Andy quickly accepted.

Andy made a killing at the expense of Peter and the other kids as his investment surged from $50 to $200 in just one week.

This simple story is repeated on the sharemarket day after day as changes occur in the investment environment, from rainy to sunny, and in investor perceptions, from negative to positive.

Private equity firms try to copy Andy and the more naive investors they can entice then the greater the price tension and the more they will receive when selling out.

That doesn't mean that private equity IPOs should be avoided at all cost - Freightways was a private equity IPO - but it does mean that investors need to assess a number of important issues including;

* Are the private equity investors selling 100 per cent of their holding?

* Is the management team selling out or retaining a meaningful shareholding?

* Are any of the IPO proceeds going into the company to enable it to grow?

* How much debt will the new listed company have?

Myer was established in Bendigo in 1900 and expanded into Melbourne in 1911. In 1961 and 1983 it acquired businesses in Sydney and in 1985 merged with G.J.Coles to form Coles Myer.

In 2006 Myer was sold to a private equity consortium, including Texas Pacific Group, Newbridge Capital, Blum Capital, and the Myer family for A$1.4 billion ($1.7 billion).

Myer's IPO is complex because the prospectus outlines potential outcomes rather than exact figures. For example:

* The private equity consortium may sell between 80 per cent and 100 per cent of its pre-offer shareholding with its shareholding going from 81.5 per cent at present to between 13.5 per cent and zero after the issue.

* The Myers family can also sell between 80 per cent and 100 per cent of its holdings with its stake going from 8.8 per cent to between 1.5 per cent and zero.

* Current and former employees, and certain key contractors, can sell up to 3.7 million shares, leaving them with around 7.7 per cent after the offer, compared with 9.8 per cent at present.

* The offer price, which is expected to be between A$3.90 and A$4.90 a share, will be determined after the institutional book build.

The issue will raise between A$1.94 billion and A$2.34 billion, with A$1.51 billion to A$1.9 billion going to existing shareholders, A$315 million will be used to repay debt and the remaining A$108 million to A$119 million will be used to meet the IPO costs.

The good news is that management will have a reasonable shareholding after the offer. The bad news is that the private equity investors and Myer family could sell all of their shareholdings, new capital will be used to repay debt rather than fund growth and the company will still be fairly highly geared.

The timing and the structure of the IPO is brilliant as far as the sellers are concerned. The timing is great because it has stopped raining and the sun is shining again as far as investors are concerned.

Myer is also giving priority to its 3.1 million Myer One customers, who are entitled to at least A$2000 worth of shares.

The Myer One customers are the potential naive investors in the Myer IPO. The more of these that the vendors can attract to the offer, the higher the price they will receive.

Approximately 155,000 Myer One customers have shown interest in buying new shares. This reduces the number of shares available for fund managers and creates price tension, which is a major objective of the vendors.

There is no specific information on the Kathmandu IPO but there has also been a huge amount of pre-issue publicity aimed at attracting widespread investor interest.

The company opened its first store in Australia in 1987 and in New Zealand in 1991. It now has 56 per cent of sales in Australia, 39 per cent in New Zealand and 5 per cent in the UK.

Jan Cameron sold the company to a consortium of investors for a reported $300 million in 2006. This consortium consists of Quadrant Private Equity with 49 per cent, two Goldman Sachs JBWere private equity funds have 49 per cent and management has 2 per cent. The company is now reportedly worth far more than the $300 million paid to Jan Cameron.

Kathmandu is a very successful company but investors should carefully scrutinise a number of issues when the prospectus is available. These include the issue price, the post-issue shareholdings of the private equity funds and management, the company's gearing and, last but not least, what could happen to its share price when it rains again.

* Disclosure of interest: Brian Gaynor is an executive director of Milford Asset Management.