How fund managers decipher the tricks of private equity IPOs Date December 4, 2015 - 8:20PM
Poor stock management forced Dick Smith to write off $60 million of inventory. Profit downgrades from Dick Smith and Spotless in the past week have undermined the outlook for future initial public offerings coming out of private equity hands.
Seasoned investors look at all floats with a trained eye, but even the best of them can miss the warning signs that distinguish a quality business from a dog.
The IPO boom, now in its third year, hints at a natural slowdown in the number of new businesses coming to market. But sometimes markets are indiscriminate. Much in the way that a rising tide floats all boats, a bad float sinks all IPOs. New floats can sometimes revive familiar names, so discount history at your peril. Photo: Glenn Hunt "If you get too many private-equity-backed floats disappointing, and we've had a couple in a row now, that might knock the stuffing out of the list of the next candidates," says fund manager Steve Black of the Pengana Emerging Companies Fund. But ignoring all IPOs, even the private-equity-sponsored ones, may not be smart either.
"The reality is since the IPO cycle started two years ago, investors have had a very good experience: the average gain on issue price is very strong," he says, having picked up stocks such as Bellamy's and Mantra. However there is a cyclical element too: "History shows you the better floats are usually in the first year."
Mr Black treads warily where he sees a prospectus that points to strong margin growth, and looks for signs of under-investment.
"In private hands behind closed doors, they can under-invest in the business, strip it of cash and therefore when it's spat back on the market there may be two or three years of catch-up capital investment. Arguably that's what happened with Myer."
It turns out a lot can change quickly within a newly listed business. Spotless' October 22 annual meeting commentary betrayed no signs of the problems disclosed in its trading update December 2. On August 26, two months before the AGM, Pacific Equity Partners sold their remaining shares in the company.
So investors could do worse than paying close attention to the escrow date. That is, the point in the life of a newly listed company when the original investors – in this case private equity, but also founders and management – are allowed to cash out their stakes. Good-faith gesture Not all floats suffer after escrow passes, but it is a useful test. The whole point of escrow is that it represents a good-faith gesture by the vendors where they keep some skin in the game after selling down in the IPO. There could be further conditions attached such as meeting prospectus targets and the disclosure of profits.
In the case of Dick Smith, August 19, 2014 was an inflection point of sorts, because about one month after that escrow period passed, Anchorage sold around $100 million of stock at $2.22. Since then Dick Smith shares lost 80 per cent of their value. Even before Monday's 58 per cent drop in Dick Smith shares, the stock was down 66 per cent since the critical escrow date.
The private equity model does not lend itself to long-term investments, so an exit is inevitable.
"Generally in some of these floats, the time at which they're escrowed is really quite a meaningful point over when PE has confidence in the earnings of a company," says fund manager Julian Beaumont of Bennelong Australian Equity Partners. "Often that's 12 to 24 months."
As for businesses which are making their second appearance on the ASX, some scepticism is warranted. "These companies don't really change, they just get bought and sold, and the reality is that they mostly remain as pretty average businesses; Leopards don't change their spots," Mr Beaumont cautions.
"Amazingly, investors have been surprised by their performance, when they all have a long-term track record on the market, and they have just reverted to their old ways."
Other floats have flourished after distancing themselves from private equity. APN Outdoor's vendors – Quadrant - quit the register at $3.31 a share and $3.63 a share through 2015; the stock traded at $5.49 on Friday.
Heavy levels of provisioning present another warning signal; this can suggest creative accounting where cash outflows are concealed in provisions instead of in the profit and loss statement.
DSH Price at posting:
39.0¢ Sentiment: None Disclosure: Not Held
