Exit, Pursued by a BearPrivate equity firms are trying to cash out of their investments. Uh-oh.
Posted Wednesday, Oct. 14, 2009, at 6:00 PM ET
The stock market has rallied impressively since this spring and closed above 10,000 for the first time in about a year. The S&P 500 is up 60 percent since the sages were declaring an Obama bear market in March. (In fact, the bottom came precisely when the Wall Street Journal editorial page published economist Michael Boskin's piece "Obama's Radicalism is Killing the Dow.") Even so, investors should be worrying. The rally has occurred as unemployment has risen and housing has continued to struggle. Plus, it's October, a month in which bad things have frequently happened in the bourses.
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StumbleUponPerhaps the most compelling reason of all for investors to fret is that private equity firms are selling shares in companies they control to the public. Blackstone Group CEO Stephen Schwarzman is feeling optimistic and, as Reuters reported earlier this week, the private equity firms he runs plans to take as many as eight companies in its portfolio public. Last week, Blackstone filed a $100 million IPO for Team Health, a hospital-staffing company it controls. As I predicted in back in June, private equity giant KKR is planning an IPO for Dollar General. Sources suggest that HCA, the hospital chain taken private by in November 2006 by KKR, Bain Capital, and Merrill Lynch's private equity arm, could be taken public soon as well. RailAmerica, a railroad operator taken private by Fortress Investment Group in the spring of 2007, had an IPO earlier this week.
Why could a slew of such public offerings be bad news for the stock markets? After all, the billionaires behind these private equity firms are offering individual investors like you and me the opportunity to join them as shareholders of companies that have benefitted from their guidance and counsel.
That's exactly why we should beware. Generally speaking, private equity investors are very smart traders. Stephen Schwarzman and Henry Kravis have amassed large fortunes because they've figured out how to buy low (using lots of borrowed money) and sell high. You'll recall that the Blackstone Group's ultimate offering—the sale of shares in itself to the public—came in June 2007, when the Dow was at about 13,500, close to the top. The IPO price marked a top for Blackstone Group's stock, which fell almost immediately and now stands about 45 percent below the offering price.
In a typical public offering of stock, a company creates shares and sells them to the public, with the cash raised going into its coffers. The public is thus dealt in on future gains. In initial public offerings of privately held companies—especially of venture-capital and private-equity backed firms—it's more common for existing shareholders to sell big chunks of their own holdings to the public. Much of the cash raised in these IPOs doesn't go to the company to pay down debt or fund future investment. It goes into the pockets of the shareholders, who often substantially reduce their holdings by offloading their stakes on less sophisticated investors. That's why private equity types refer to such events as "exits." Take this week's RailAmerica IPO. A total of 22 million shares were sold to the public at $15 per share, raising about $300 million after fees. But fewer than half—10.5 million shares—were sold by the company. The rest were sold by Fortress. So only about $157.5 million of the total raised went to the company. The rest went to Fortress, which got to shed some of its investment in RailAmerica and pocket a small fortune for its owners. RailAmerica could certainly have used all that $300 million. It has more than $700 million in debt. In the first half of 2009, interest costs ate up about three-fourths of operating income, and its underlying business is slumping. (Go here and click on the Sept. 29 registration statement to see the latest data.) In its first two days of trading, RailAmerica's stock has fallen. (Fortress, it should be noted, still owns most of the company's shares.)
Private equity firms like to talk about creating value over the long term. But like all good investors, they're opportunistic. They jump at opportunities to acquire companies when owners are desperate, and they leap at opportunities to cash out when the public debt and stock markets are in a credulous phase. In the go-go credit years, private equity firms minted money by having companies they controlled issue bonds and use the proceeds to pay the owners a special dividend. The credit crisis put an end to that strategy. So they're back to extracting value by selling stock. And they can do so only when markets are comparatively forgiving and complacent, when investors have let down their guard. (There were very few IPOs and private equity exits in March and April, when tolerance for risk was extremely low.) If a slew of private-equity-backed cash-out IPOs find a rapturous reception in coming months, it could be a warning that investors are become as irrationally exuberant as they were when the Dow first crossed 10,000 in the spring of 1999.
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There's a better explanation. A lot of private equity and venture funds have 8-12-year lifespans, by design. There are a lot of 1999 and 2000 vintage funds that simply MUST cash out, regardless of conditions. Whatever the stock market activity since the dotcom bust in mid-2000, there really hasn't been a time when the PE community thought it was a great environment for IPOs. It was suckier six months ago than was in 2005, or than it is now, but there was never a great time since early 2000 to go public.
A perfect example is OpenTable, which is by all accounts a successful IPO. But that company isn't a growth story like Google or Amazon, it's a nice little cash generator - better off private. OT didn't need to raise money in the stock market, rather their venture investors needed an exit. Their funds were end-of-life; Their time was up.
I know this for a fact. So:
1. Don't overweight market conditions, illiquid investors need exits for all kinds of reasons.
2. Good companies make good IPOs no matter what the market conditions - and don't forget the 6-12 month lockups- not even Blackstone can time markets that well.
-- moodyguppy
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You emphasize the fund lifespan but the key word is illiquid. These funds need cash in a stressed economy. They were able to ride out the storm but once the storm has passed, they need to raise some cash once the equity markets are reasonably healthy.
-- Odie
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Good article Daniel, but when you should really be worried is when the PE firms start doing offerings on their own G.P. interest (i.e. BX in summer 2007).
A lot of these portfolio company IPOs are long overdue; there will always be a lot of pent up supply when nothing happens for a year. You could view the return of IPOs as a good thing, as the reverse situation---where there are no public offerings at all--is usually considered to be pretty bad. I know, I know...that's pretty pollyannish.
-- Bentoniani
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