Private Equity Article

7/28/2019 Private Equity Article

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Analysis of IPO as an exit strategy for Private

Equity firms in the present scenario:

Private equity is essentially a way to invest in some asset that isn't publicly traded, or toinvest in a publicly traded asset with the intention of taking it private. In India the conceptof PE is very young, dating back to 1990s. PE funds raise money from high net worthindividuals, financial institutions, etc. for a period of seven-ten years and then invest inopportunities as and when they arise, either in early-stage, maturing or even publiccompanies. These firms exert a tremendous amount of influence on their portfoliocompanies. They perform a wide range of activities such as strategic guidance, financingexpertise or the restructuring of the companies operating business. In doing so, they aim at

creating profits for their investors by increasing the value of the portfolio companies. Whileprivate equity firms sometimes pay themselves back using the acquired company's profits,this isn't their principal moneymaking area. Since the target is also to exit the investment ina few years and return money to investors this value creation can only be realized at theexit, i.e. when the Private Equity firm sells off its stake in the respective portfolio company.Rather than making money from guaranteed minimum dividends, etc., private equity firmshave been generating most of their profit from the exit event or the time when they eithersell the company to another private entity or return it to the public markets, presumablyfor a higher price than they paid originally.

Private Equity houses have a number of routes to exit from their investments. They are:

Initial Public Offerings

Recapitalization

Merger Sale to another private group ( Secondary Buyout )

Sale to a Strategic Buyer

One of these exit strategies is to float the portfolio company via an Initial Public Offering

through the stock market. The IPO is seen by many PE firms as the ideal exit route for their

investment. It is a notion that these firms can achieve a higher ROI in an IPO than in a trade

sale where the PE firm sells the company it owns to another player in the same field . This

article focuses on how important is the IPO route to exit.

The deal teams constantly monitor the capital markets for suitable times to do an InitialPublic Offering or find a strategic investor to sell to. Selling the shares of an IPO companyinto the primary stock market usually earns large profits for the initial shareholders as IPOshares can be sold into the market at a premium over their pre-IPO value. More profitablethe IPO company and the more promising the companys financial present and futu re , thehigher is the price at which the shares can be sold into the market. For Private Equityinvestors an IPOs purpose is therefore to raise as much equity capital and thereby

generate high returns on their investments. IPO also provide opportunities for liquidity of


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PE firms and enable their portfolio companies to clean up their balance sheets byincreasing equity and using the proceeds of an offering to pay off outstanding debt.

IPO as an exit strategy is preferred by PE firms when the market conditions are normal or

the market is in a boom as this would help them raise more amount of funds because of the

fact that investors would reluctantly pay a premium for their shares and thus wouldincrease the earnings of the PE firm. On the other hand many private equity-backed IPOs,

like that of Generac Holdings , have also seen reductions in offering size as volatility had

returned to the stock market in 2010 amid the European financial crisis and certain

macroeconomic factors .

An IPO may deliver higher returns than other forms of divestment through the higher

valuations that may be achieved in public equity market. It may also provide the company

with continued access to further equity finance to secure future growth. However the IPO

process can be costly, with an outcome that may be deemed to be uncertain for PE firms

looking for quick and sure exit. Furthermore, IPOs typically involve lock-in agreements

with the PE firms to retain a stake in the company for some period after the floatation that

may not result in complete exit.

As an alternative to floating a company on the stock market in an IPO , the PE firms can exit

from their investments by selling off their stakes to other companies ( trade sale ) or to

another PE firm or financial institution . They can accept a buy back from companys

management or they may have to write off the investment if it has not been successful.

Recent Trends

Market conditions after the downturn caused by the global recession in mid-2008, havestarted to improve, allowing private equity firms to exit some of the investments madeduring the boom era prior to 2008 . So, 2010 and 2011 YTD has been a successful year asfar as PE-based IPO is concerned.

The figure 1 below shows that during 2010, 145 IPOs and share sales had occurred. The figure 2 shows that these IPOs raised an aggregate value of $38.7 billion, twice

the aggregate value seen in 2009, and a twelve-fold increase in comparison to 2008,the lowest point for IPO activity in recent years.

Figure 3 shows that 17% of PE-backed exits in 2010 came from IPOs and sharesales, a significant increase from 2008, when only 5% of exits were made via IPO


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Figure 1

Figure 2

0

5

10

15

20

25

30Aggregate exit value

Aggregate exit value

0

10

20

30

40

50

60

70

8090

100

No: of deals

No: of deals


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Figure 3

16 125

15 17 15

53 5657

5153 53

30 32

31 16

26 25

1 1 818

4 7

0

20

40

60

80

100

120

2006 2007 2008 2009 2010 2011 YTD

Restructuring(%)

Sale to GP(%)

Trade Sale(%)

IPO(%)

Some Facts:

145 IPOs and share sales with an aggregate value of $38.7 billionoccurred in 2010. This is twice the aggregate value seen in 2009 and a12-fold increase from 2008.

17% of private equity-backed exits in 2010 came from IPOs; this is asignificant increase from 2008 when they accounted for 5%.

PE-backed IPOs in 2010 surpassed pre-financial crisis era levels with a12% and 29% increase in the number of PE-backed flotations incomparison to 2006 and 2007, respectively.

In 2011 to date there have been 11 IPO exits worth a collective $10.2billion. This includes the refloating of Kinder Morgan , the only secondexit ever to raise over $2 billion. Shares were priced above the expectedrange due to strong demand.

HCA Holdings, the largest hospital operator in the US, which priced145 million shares to raise US$4.4b was the third exit ever to raise over$2 billion.

Trade sales continue to dominate the exit market, accounting for 53%of exits in 2011 to date. Secondary Buyouts and restructurings accountfor the remaining 25% and 7% respectively.


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The number of private equity-backed buyout IPO and private placement exitsincreased significantly during 2010, and it is hoped that the trend is set to continueover the coming months because some of the PE deals which were made in the pre-crisis period are to mature and some firms who had postponed their exit due to thefinancial downturn in 2008 are looking forward to divest their holdings in their

portfolio companies.

The returning appetite of investors has fuelled several notable PE-backedIPOs/private placements since the start of 2010.

Despite a global events-driven slowdown across the broader IPO market, PE-backed

companies executed some of the largest sponsored IPOs in history in the first

quarter of 2011. In aggregate, PE-backed companies raised US$13.5b in 20 separate

transactions in the first three months of this year, compared to US$7.2b in 27 deals

in the same period in 2010.

Despite ongoing uncertainties in the markets, the first months of 2011 saw therecord for the largest-ever PE-backed IPO broken twice in rapid succession and

proved to be record breakers.

In early February, Houston-based pipeline operator Kinder Morgan

completed a US$3.3b IPO on the NYSE. For a short period of only a few

weeks, this was the largest PE-backed IPO on record.

Then came HCA Holdings, the largest hospital operator in the US, whichpriced 145 million shares to raise US$4.4b in proceeds, making it the largestsponsored offering in history, and the largest IPO on a US exchange sinceGeneral Motors raised US$18.1b in August 2010.

The floatation of TDC A/S, a Danish telecommunications company which was

backed by Apax Partners, Blackstone, KKR, Permira and Providence EquityPartners and was purchased back in 2006 for DKK 76 billion, one of thelargest buyout deals in Europe at the time. The firms offering was fully

subscribed in December 2010, raising DKK 12.3 billion.

Market volatility stemming from unrest in the Middle East and the disaster in Japan

took its toll on new issuance momentum in the latter half of the first quarter .

Globally, 294 companies (both sponsored and non-sponsored) raised US$46.9b over

the last three months, down 13% from the same period in 2010, when companies

raised US$54.1b in 300 initial public offerings. In aggregate, eight companies backedby PE firms pulled their IPOs in the first quarter due to decrease in attractiveness of

the market conditions.

One reason for anticipated increase in PE-backed IPO is the large buyouts during

the boom years of 2005 to 2007 due to which private equity firms now own many

of the biggest companies in any given sector, a big change from the past. Another


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reason is that private equity-backed companies are going to make up a majority

share of the IPO market for some time to come, as firms take public the companies

that went private during the boom years.

By the end of the quarter1 2011, 70% of first quarters PE-backed IPOs weretrading above their IPO price, with an average increase over issuance price of

14.0%. Chinese internet company Qihoo 360 Technology, backed by CDH China

Holdings, was the best-performing IPO of the quarter. The company, which

operates in the mobile and internet security space, opened up 86% in its NYSE

debut, and closed out March up 104%, making it the highest-performing US IPO of

the quarter. The quarters large IPOs did well also Nielsen Holdings, in particular.

The shares gained 18.7% over the companys IPO price. 2011 could be the biggest

on record for PE-backed IPOs, given increasing demand for new issuances and

ample supply. PE-backed IPOs have performed well as a group with investors

seeing good returns on deals both recently and over the last year.

Some of the notable PE-backed IPO in recent times:


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US Leads the world in listing IPO based PE exit:

There were a total of 25 US IPOs recorded in NYSE which raised an amount equal to $14.7

billion. NYSE Euronext lead IPO Markets Globally in First-Quarter 2011 . This strong IPO

momentum was backed by various PE-backed IPO deals , where some deals have proved to

be the largest of its kind in the world till date , the most important ones being IPOs of HCA

Holdings , Kinder Morgan ,The NielsenCompany and BankUnited .

HCA Holdings IPO - HCA the hospital chain sold 126.2 million shares at $30, the top of therange initially proposed. . HCA was taken private during the boom period of 2006 in a $21billion deal, excluding debt, that involved Bain, KKR , Bank of America Corp , Citigroup Incand HCA's founder, healthcare mogul Dr. Thomas F. Frist Jr. It went public on 9 th March2011 with the firm raising $3.79 billion in its IPO making it the largest US PE-backed IPO.After the IPO, the leveraged buyout investors and the Frist family are expected to morethan triple their 2006 investment. HCA's success is expected to encourage a slew of similar

IPOs of private equity investments made at the height of the credit bubble in 2005 to 2007.Kinder Morgans IPO - Mr Kinder the CEO of Kinder Morgan and the private equity firms,which included funds Goldman Sachs, Carlyle Group, Riverstone Holdings and HighstarCapital, took the company private in 2006 for $22bn, which included $15bn in equity alongwith $7bn in debt. In February 2011, the firm went public when its IPO raised an amount of$2.9 billions making it the second largest PE-backed IPO. It sold 95.5 mln shares vs 80 mlnexpected and it is the biggest U.S. energy IPO since 1998.

IPO as an exit strategy .. A hit or a miss!According to data reported by Thompson Reuters IPOs lose sheen for private equity firms

looking to exit as more than 20 venture-backed IPOs were completed in the first six

months of 2010, but only three of those offerings priced above their filing range. The

number of IPOs completed in 2010 was higher than 2009 but during this first six month

period of 2009 , more IPOs were abandoned (71) than completed (68). Accordingly, an IPO

may not be the best exit strategy for every portfolio company, but the public markets do

present an exit and as firms are eager to liquidate their portfolios, they continue to

compare an IPO to other exit options.

There is also underpricing involved in an IPO. IPO underpricing arises by information

asymmetries associated with a firm's first public equity offering. Information asymmetries

between the firm, the underwriters, the informed investors and the uninformed investors

create uncertainty regarding the security pricing which results in the discount of those
http://markets.ft.com/tearsheets/performance.asp?s=sg:AP4http://markets.ft.com/tearsheets/performance.asp?s=sg:AP4


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securities at the time of the initial public offering and thus reducing the returns to these

firms.

Rising inflation and interest rates have raised fears the markets may not improve much in

the next five-six months. PE firms that wanted to list their portfolio companies three-fourmonths ago now are wanting to opt for other modes of exit.

IPO and Other exit strategies:

Fear of private equity firms practicing window dressing when presenting investeecompanies to public markets is common in the IPO investor market. Private equityfirms wish to maximise their exit value and, indeed, have a fiduciary duty to theirLimited Partners to do so. Accordingly, they maximise their exit values byshowcasing investee companies in the best possible light when presenting them to

investors at IPO. While private equity firms are thought to add considerable value toinvestee companies through their enhanced access to resources and improvedcorporate governance, not all private equity activities at IPO are considered to havelasting positive effects. Substantial concerns have been voiced over cash stripping,accounting manipulation and short-term cost cutting to maximise reported profits.Due to such reasons other methods of exit would give a better picture and properinformation to the investors.

One needs to bear in mind that besides the high notional valuation that an IPO maycreate in some circumstances, the certainty of being able to exit on account ofliquidity, price realisation and regulatory constraints may make a trade sale or astrategic sale or an M&A exit a more real and profitable exit. Time value of money isalso paramount for PE investors, as most of them invest with a certain time-specifichorizon.

The end of 2010 witnessed one among the largest exits in the Indian private equitysector, wherein PE majors Actis and Sequoia together made a cool $500-millionprofit through the sale of portfolio firm Paras Pharma. There is also an anticipationof a big-ticket M&A deal, in which General Atlantic is to exit Patni Computers.

In the private equity cycle, the choice of a successful method to exit its investmentsis one of the most critical choices faced by private equity investors. Of the exit

options faced by private equity firms secondary buyout has gained hugeimportance since 2000. The greater accessibility of the credit market, manifested inthe loosening of covenants and the reduction in spreads charged by the banks madethe purchasing private equity firms willing to pay more and so the selling privateequity firm took advantage of this by selling at a higher price. Although secondarybuyouts are not the preferred exit route, private equity funds are not willing to giveup on the benefits of a quick exit and a better return .


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Future Prospects:

There are currently 56 PE-backed companies in registration to go public, which could raise

an aggregate US$14.7b across global exchanges. In addition to companies that have

formally filed, the sometimes volatile nature of the 2009-2010 market has also led to a

sizeable shadow pipeline of PE-backed companies that either have yet to make an initial

filing, or previously withdrew an IPO due to negative market conditions. Many of these

companies are likely to pursue an IPO during 2011. As PE firms seek to exit some of the

largest businesses acquired between 2005 and 2008, this year could eclipse the 2007 PE-

backed IPO peak, when US$58b was raised from IPOs. Investor appetite for such deals has

been tested and reinforced over the last several quarters benefiting from continued

momentum in the global equities markets. In the absence of additional economic shocks,

the conditions appear to be ripe for one of the most active years on record.

The year 2011 is likely to witness maximum number of private equity/venture capital exitsin the history of Indian PE industry. The typical cycle of investment-exit is expected to getcompleted in 2010-11 for many PE investors here.There will be more exits in 2011 ascompared to previous years, since the portfolio companies are getting matured.Investments made in 2003, 04 and 05 are matured now and will be able to provide goodreturns for investors. December 2010 witnessed the largest ever exit in PE, wherein Actisand Sequoia together made a $500-million profit through the sale of portfolio firm ParasPharma.

2011 will witness the continuation of exit process, which began in 2010. The maximumnumber of PE/VC investments took place in 2006-2007 when the balance sheets as well as

the profitability of the portfolio firms were pretty good. The downturn made the year 2009tough for exits and 2010 saw change in performance and the euphoria was back. As thereflection, more exits are expected in 2011 and 2012.

According to VCCedge, exits worth $5 billion took place in 2010 through 164 deals against

103 exit deals worth mere $2.1 billion in 2009. Buyback was the preferred route in 2010 as

deals worth $1.7 billion took place. The next preferred routes were open market ($1.5

billion) and M&A ($1.2 billion).

There is an increased interest from foreign companies looking at buyouts in India. As they

are aggressively looking to expand growth markets, they are willing to pay a premium forthe right assets; Indian promoters see them bringing in vast experience and technologyapart from capital. A number of private equity players who have taken up controllingequity positions in the past will continue to use this route to exit their holdings at anattractive multiple.


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As market conditions have started to improve, private equity firms have been able to exitsome of the investments made during the boom era. There have already been severalnotable private equity-backed buyout exits in 2011, and with numerous forthcomingproposed deals in the pipeline, 2011 looks set to be a record breaking year for these exits.

However, investors are now more cautious about the level of leverage, at which a companyoperates, with many now expecting the private equity company to hold stakes in theoperating company and use the proceeds from the IPO to pay down debt. This could impacton the success of the IPOs of the more highly leveraged companies from which privateequity firms are seeking to exit.

PE/VC EXITS

Year

2009 2010

Exitvolume

Exit

value

($ mn)

Exitvolume

Exit value($ mn)

Buyback 6 500 15 1695.32

IPO 2 31.64 15 502.22

M&A 18 157.97 40 1238.13

Open

market 69 1390.1 76 1448.54

Secondary

sales8 78.17 18 160.85

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