Private equity-backed IPOs (Initial Public Offerings) have come under significant scrutiny following several high-profile failures: but are these representative or merely anomalous blights on an otherwise well-performing sector?
Last week, the proposed private-equity backed listing of Guvera music was blocked by the ASX following concerns raised by the Australian Shareholders Association over its business model and valuation based on earnings.
Guvera were looking to raise $100 million in an IPO that valued the business at more than $1.3 billion, despite the fact that it lost $81 million last financial year on revenue of just $1.2 million. The move by the ASX follows Guvera re-issuing its prospectus after scrutiny from the Australian Securities and Investment Commission (ASIC).
Another notorious PE-backed IPO was the 2012 float of Dick Smith, backed by Anchorage Capital. It ended in significant losses for initial investors and was dubbed by Forager Funds Management analyst Matt Ryan as "one of the great heists of all time".
The high-profile the IPO of Myer, backed by TPG Capital, also performed poorly: Myer listed at $4.10 per share, fell to $3.75 per share on the first day of trade, and fell to $1.20 per share by the end of 2015.
However, several other PE-backed IPOs have performed strongly between 2013 and 2015, including Aconex, Ooh! Media and Mantra group. This raises the question of whether the average PE-backed IPO underperformance and what factors might investors look out for.
Do PE-backed IPOs necessarily underperform?
So should investors make a rule to avoid PE-backed IPOs in general? In fact, there is little evidence that PE-backed or VC-backed IPOs underperform for investors. In Australia, from 1994 to 2005, the difference between VC/PE backed IPOs and other IPOs is not statistically significant.
The Australian Venture Capital Association Limited (AVCAL) in conjunction with Rothschild reports that while non-PE backed IPOs did perform better in 2015 than did PE backed ones, PE-backed IPOs outperformed from 2013-2015. AVCAL argues that "PE-backed IPOs strongly outperform non-PE backed IPOs after the first year of listing", with PE-backed IPOs outperforming non-PE backed IPOs by 23% during that one year after listing.
Similarly, Deloitte argues that "the performance of private equity backed listings suggests results are far more positive than market sentiment reflects" and that $1 invested in each PE-backed IPO since the beginning of 2013 would yield an average return of 48% by the end of 2015.
Using the set of ASX listings for at least A$100 million reported by AVCAL (and their classification of whether a firm is PE-backed), we can look at the average value of $1 invested in each of the PE-backed IPOs versus $1 invested in each of the non-PE backed IPOs.
When doing so, to avoid the possibility of outlying PE-backed firms experiencing super-positive returns and this biasing the results, the daily return is winsorized (limiting of extreme values) and any return over 100% is excluded (this adjustment actually biases in favor of the non-PE backed IPOs).
The below graph, which is consistent with that produced in the AVCAL report, demonstrates that PE-backed IPOs outperform their non-PE backed counterparts. A similar trend appears over longer two-year and three-year time horizons (though, more recent IPOs will not yet have had the opportunity to accrue such a lengthy return history).
Seven factors investors should consider:
This suggests that PE-backed IPOs do not necessarily underperform. But clearly, not all PE-backed IPOs will outperform either. So here are seven factors associated with post-IPO performance investors should look for:
Length of investment. The length of the PE-fund's involvement with the company will help to indicate if the PE fund actually contributed to the company. In several poorly performing PE-backed IPOs (such as Myer and Dick Smith) the PE fund had invested for only one to two years. When at least part of that time is also spent preparing the company for listing, this would likely be insufficient time to fully transform the company. Clearly, the time required to improve the company will depend on its complexity, but a typical situation would often call for several years of PE-investment prior to IPO.
Prior litigations. Companies backed by VC and PE funds that have been sued recently (or for whom their portfolio companies have been sued) warrant further scrutiny. Funds that have been sued have difficulty attracting future funding and if investors are reticent to invest in the fund itself, it could imply beliefs about how the fund might manage companies it lists on the market.
The backer's portfolio size. VC and PE funds that are larger and invest in more portfolio companies tend to perform worse because they spread themselves too thinly across portfolio companies, suggesting that their portfolio companies my perform worse.
Distance between the company and its backers. The geographic distance between the PE (or VC) fund and the portfolio company could be a concern. For example, an overseas based fund might face greater barriers to a successful outcome.
Number of backers. A company with more interested pre-IPO investors is likely to have greater growth prospects and has more scope for the disparate investors to pool their expertise to aid the company. However, there are diminishing returns to having more backers, with each additional supporter likely to have less scope to incrementally benefit the company.
Geographic diversification of the backers. To an extent, a backer who has supported more companies in multiple industries and multiple regions can have gained a breadth of experience and connections with which to impart the portfolio company. There are limits, with excess diversification potentially causing the fund to spread its attention too widely. The fund's record would help to indicate whether such diversification has benefited the fund's investments previously.
PE fund's continued involvement in the company. It is generally a positive signal if the PE fund that continues involvement in the form of board positions or ownership stakes (exceeding the minimum time, or amount, legally required).
Essentially, while investors should always examine each IPO on its merits, there is no reason to avoid PE-backed IPOs per se.
Mark Humphrey-Jenner is an Associate Professor of Finance at UNSW Business School. His research interests are mainly in corporate governance and in law & finance. His work has appeared in major finance journals such as Journal of Financial Economics, Review of Financial Studies, and Journal of Financial and Quantitative Analysis. He received his PhD in finance from UNSW in 2012 and has also received qualifications in law.