Private equity firms will, equity bankers hope, be the source of much primary market activity this year. However, private equity firms say they are still keen to avoid using the public equity market to exit holdings. Harry Wilson finds out why 2005 won't be the year of private equity IPOs.
ECI Partners and the Carlyle Group have, you would think, little in common. The first is a small UK-focused private equity firm investing in small to mid-cap companies. The other is a global titan of the private equity world, with over $18bn of assets, and some of the world's richest and most secretive individuals as investors.
However, they share two characteristics ? never being dependent on the public equity market for an exit, and a preference for private equity and trade sales over flotations.
Equity bankers are hopeful that private equity exits will drive European IPO volumes this year, but some capital markets professionals are doubtful and warn of putting false hopes on the private equity industry.
?We don't see a private equity-fuelled IPO bonanza this year,? says Tom Troubridge, head of PricewaterhouseCooper's (PwC) London capital markets group. ?Last year there was a perception that it was a buyers' market, which led private equity firms to withdraw from the public equity market, and we haven't seen them come back.?
Many asset classes, including equities, have disappointed investors over the past three years, and investors have looked for alternative investments that offer better yield.
Private equity firms have been among the main beneficiaries of this trend. At the same time, banks have been prepared to lend to them at increasingly low rates, providing funds with a plentiful and cheap source of capital.
But, despite private equity firms making large investments, only a small proportion of them have returned to the market with IPOs. Equity bankers reason that at some point private equity firms must turn to the stock market to exit their holdings, and 2005, many say, could be that year.
The logic of equity bankers is broadly correct. While innovations such as private equity to private equity sales have become popular, this is not a complete solution for private equity funds, which like a choice of exit routes.
Christopher Finn, a managing director in Carlyle's London-based European business, is blunt about his firm's investment strategy. ?A key area we look at when investing is the exit,? he says. ?We would not go into an investment if the only exit was the public market.?
Finn concedes that IPOs can be a useful way out. ?We are more comfortable with considering flotations as well as trade sales for larger companies, as their size makes them easier to float.? However, he says, ?the priority is always to keep the exit timing in our hands.?
For different reasons, ECI also finds that the public equity market is rarely an option when it is considering an exit. ?The companies we own generally appeal to trade buyers. However, increasingly we are getting interest from larger private equity firms,? says James Stewart, a managing director at ECI, based in London.
Like Finn, Stewart is not wholly opposed to flotations. ?In the mid-market you have to be flexible when looking at exit opportunities,? he says. ?When we sold Holiday Autos to Lastminute.com we accepted an offer of cash plus Lastminute shares, after taking a view on the stock.?
Private equity firms are reluctant to listen to the overtures of equity bankers who argue the time is right to return to the public equity market. Between the stock market collapse of 2001 and the recovery in valuations of the last year and a half, these firms have found ways of avoiding the public market altogether.
Funds have been particularly worried by the equity market's sometimes irrational response to new issues.
The attempted IPO last year of German auto parts retailer and repair company Auto-Teile Unger is a case in point.
Private equity backer Doughty Hanson pulled the plug on the Eu1bn IPO in May, only weeks before the deal was due to be priced, and after pre-marketing had already begun, because of the low valuation placed on the company.
One month later, Doughty Hanson sold ATU to US private equity firm KKR for $1.75bn. That the firm chose to sell the business to KKR highlighted two trends in the private equity market that became increasingly apparent last year.
First, there is the popularity within the private equity industry of exiting a holding through a sale to another private equity firm ? a kind of private equity industry version of pass the parcel.
Second, private equity firms are often willing to offer more than is available from the public equity market.
Consider last year's dual track private equity auction and simultaneous IPO of Saga, the UK travel and insurance company for the over-50s age group. Here UBS played the public equity market against the private equity market to push up the price of the company.
In October, private equity firm Charterhouse paid £1.35bn for Saga, over £350m more than the public equity market was prepared to pay.
The irrationality of the public equity market can also be seen in the way investors can become almost superstitious about companies whose first attempt at an IPO has failed.
?One problem with IPOs is that if the float gets pulled the market will always assume the issue is with the company,? says Finn at Carlyle. ?However, a trade buyer will look at the company in more detail, and will assess it on its individual merits.?
Moreover, a sale to another private equity firm is a far cheaper process than an IPO. Not only do flotations entail fees to a myriad range of advisers, but they do not always provide a total exit, as the private equity vendor is often obliged to retain a significant stake. A private equity auction is faster, less prone to the whims of general market sentiment, and less time-consuming for company management.
IFRS: Rocking the boat
The introduction of International Financial Reporting Standards this month has provided a further incentive to avoid the flotation route.
The equity-linked market has been particularly hit by IFRS. After record years for issuance in 2002 and 2003, volumes dried up last year as companies appreciated the impact the new standards would have. Private equity firms and the companies are now waiting to see how how IFRS will affect them.
?There are many downsides to being a public company,? says Troubridge at PwC, ?particularly at the moment when the corporate governance pendulum has swung towards tougher regulation.?
One result of IFRS has been the jump in the number of listings on the London Stock Exchange's junior Alternative Investment Market, which has opted out of the European prospectus directive. Firms listing on AIM are not generally required to report in IFRS until 2007 (though firms marketing their IPO to more than 100 investors are required to adopt IFRS).
Complying with IFRS is less onerous for smaller companies, since their financial statements are generally more straightforward, given they are unlikely to have derivatives or other complex financial instruments to account for.
However, with private equity funds increasingly investing in large companies, the impact of IFRS has been broad.
Some observers speculate that it might only be a matter of time before private equity firms turn their eyes towards companies previously considered out of their price range, such as FTSE 100 businesses.
Indeed, 2005 may become more notable for delistings than listings, as many businesses, fed up with complex corporate governance and accounting regulations, may opt to return to the private sector.
The success of AIM last year shows that demand is definitely there for a market that provides liquidity, but without crippling regulations. In 2003, AIM gained 279 new listings, compared with 47 on the main London market, and broke through the 1,000 barrier for the first time. The decision of several companies to swap their main listing for an AIM listing highlights the trend.
Capital markets professionals expect AIM to keep growing, and say if there is any IPO boom this year it will be provided by the junior market, which is starting to attract more interest from non-UK companies.
Early in the cycle
The UK's well established private equity and venture capital industry received a shock in July 2004 when the IPO of Premier Foods proved a difficult sell to cautious public equity investors, forcing the float's lead managers to price the deal at the bottom of a lowered price range.
The reaction to Premier Food's IPO led many private equity funds to reassess their plans for floating UK assets, according to Troubridge. But anyone hoping that other European markets might take up the slack is likely to be disappointed, as the private equity industry outside of the UK is generally less developed.
?Outside the UK, private equity has not been used as much,? says Troubridge. ?Those investments that have been made have yet to go full cycle, so we are not expecting to see a lot of European private equity-driven flotations any time soon.?
The French and German markets have become increasingly active over the past five years, as private equity buy-out levels have increased. In 2002, for instance, French buy-outs totalled over Eu16bn, and in 2003 German deals totalled Eu10bn.
But it is probably too early for many of these investments to come to the public equity markets this year.
While small private equity firms such as ECI Partners are an established part of the scenery in the UK, as part of a well developed ecosystem of private equity funds, the same is not true in any other European country.
Without this network of private equity firms and a large pool of investors to fund them, no European market will be able to provide the consistently high volumes of issuance that the UK does.