Private Equity IPO's--Pigs with lipstick
Private Equity IPO’s – Pigs with Lipstick?
Many years ago I was a senior analyst with
a major institution in Sydney. Part of its extensive equity portfolio was an
unlisted investment. How an unlisted investment came to be in the portfolio in
the first place is another story but at that time I was responsible for this
investment, so I closely examined its prospects.
As a shareholder in the venture, we had
access to the board papers and budgets. The firm was basically an ice cream
factory. Examining the past papers I quickly concluded that the firm was
struggling and we would be lucky to avoid writing down the investment. The
accounts told the tale, of continual operating issues, losses, and negative cash
flow. Troubles with manufacture, distribution, market positioning. The
situation looked dire. I thought we had done our dough.
The broad strategy appeared to be if the
firm could string a couple of good results together it would be promptly
floated on the ASX, thereby providing a profitable exit. No sooner as I had
scoffed at the likelihood of this plan succeeding, the situation changed
dramatically. As if by divine intervention everything in the business suddenly
fell into place. Budgets were met, operations performed, and distribution was nearly
faultless. I was accordingly gob smacked.
Promptly the plan to float was quickly put
into place. The shareholders put underwriters into place, and earnings
projections were made which portrayed a positive future of increasing earnings
over time. The firm was successfully listed and celebrations had. Again, I
stood amazed as it floated at a price that shortly beforehand would have been
unimaginable. The process was assisted by a strong bull market.
Soon afterwards the issues that had plagued
the firm beforehand reemerged. The share price fell and management was questioned
etc. etc. To me, it all appeared as if nothing much had changed except that
there were now new owners at a higher price that could fear the same issues I
had agonized over not long before.
The experience of this leveraged buyout,
what would now be called a private equity firm, left a lasting impression on me
that would permeate through my investing career. That is a deep scepticism of
floats brought to the market by incentivized sellers.
There is something about a sale from a
professional investor that is quite different from, for instance, a sale from
the government, or a spinoff from a company to its shareholders, or a sale
forced by consequence. The private sellers are highly incentivised to maximize
receipts. In fact they would be quite unhappy if new investors made a windfall
for that would imply that they had sold the firm too cheaply. Other sellers may not be so incentivized.
Years later a top 100 CFO would describe to
me dealing with PE firms as being incredibly intense. Their skill, in his
opinion, was only on achieving a low purchase price and maximizing their exit
price. His view was that was the only value they added to the transaction, but
that they were very good at it.
If we assume that an owner is highly
incented to buy low and sell high what possible actions could the owners take
to maximise short-term profit, potentially at the expense of long-term profits
and therefore maximise the sale proceeds. The aim is to engineer current
earnings, that is, what the company is being sold on, to be as attractive as
possible. All being within accepted accounting rules.
The list unfortunately is quite long. A non
exhaustive list may include, cutting research and development, cutting sales
staff or marketing, raising prices, entering into low start payment or loans,
changing depreciation, lowering investment in plant and equipment or inventory.
Running working capital down. The aim of
all this is to increase short-term profits at the expense of long-term profits.
The new owners would at some stage have to spend up to cover these
shortcomings. Profits would likely be overstated when the firm came to market.
So we come to two of the high-profile
floats over the last ten years (nb this was written some time ago), the float
of Myer and the float of Dick Smith. Without any judgment of the issues above being
issues in these floats, what can we observe about these companies from the history.
Many years ago I spoke with John Fletcher who was managing Coles but I knew
from being CEO of Brambles. I asked him how different was the management task
at Coles Myer. Part of his answer was commenting that Myer was 10% of the
revenues but 50% of the problems!
Any cursory look at the accounts would have
come to the same conclusion. Myer was an issue and had been so for years. With
revenues and profits moving all over the place, there was even a theory that
department stores were no longer relevant to the new retailing world. Coles
finally sold the firm to PE but soon after it came back, sparkling new and
transformed.
The valuation between the purchase price
(low) and sale price (high) was stark. The obvious question was had
fundamentals changed that much? Could the prospects of Myer be that different
over a relatively short period? Could management have permanently improved the
operation to that degree?
Like most PE floats there is a huge
marketing campaign accompanying the sale process. Dick Smith would follow an erringly
familiar course several years later. The similarities were quite uncanny. Poor
operation taken into the PE conversion chamber churned out relatively quickly
into a moneymaking machine. The sellers in both cases had been seasoned
retailers.
Everything in investing is easy in
hindsight. We are all wise with the results fully disclosed. Over the time
involved here I analyzed countless prospectuses, but not by coincidence I can
say that Myer and Dick Smith were not two of them.
Is it reasonable for a witch-hunt to be run
against PE floats?
Of course not, the job of the professional
investor is to analyze the information at hand. Including judging whether there
is enough information disclosed to determine whether the issues mentioned above
are not being used to pretty up results.
There have been great performances from PE
floats and disasters however the base case is that you are dealing with
professional sellers who are highly incented to maximize sale prices and drum
up a frenzy of excitement to maximize sale proceeds.
If you cannot deal with this situation then
hire someone who can. Of course, I am not suggesting that all professional investors
are up to the task!
As an aside if you were really being
offered such an attractive opportunity surely the sellers would be open to
attaching a, say, two year put! Lol. Think about it.
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