Seven ways to tell whether you should avoid a private equity-backed IPO

Private equity-backed IPOs (initial public offerings) have come under intense scrutiny in the wake of several high-profile failures: but are these representative or merely anomalous blights on an otherwise thriving sector?

Last week, the company was proposed to be listed on a stock exchange supported by private capital Guvera’s music has been blocked by the ASX following concerns raised by the Australian Shareholders Association about its business model and financial performance-based valuation.

Guvera sought to raise $100 million in an initial public offering that valued it at greater than $1.3 billion, regardless that it lost $81 million last fiscal 12 months on revenue of just $1.2 million. The ASX’s move follows Guvera’s re-issuance of its prospectus following scrutiny by the Australian Securities and Investments Commission (ASIC).

Another notorious PE-backed IPO was the debut of Anchorage Capital-backed Dick Smith in 2012. This ended in significant losses for initial investors and was called by Forager Funds Management analyst Matt Ryan as “one of the greatest robberies of all time”.

Myer’s high-profile IPO, backed by TPG Capital, also performed poorly: Myer listed on $4.10 per shareit fell $3.75 per share on its first day of trading and dropped to $1.20 per share by the end of 2015.

However, several other PE-backed IPOs performed well between 2013 and 2015, including Aconex, oh! Media and Mantra Group. This raises the query of whether the average PE-backed IPO is underperforming and what aspects investors may be being attentive to.

Do PE-backed IPOs at all times underperform?

So should investors generally adopt a policy of avoiding PE-backed IPOs? In fact, there is little evidence that PE or VC-backed IPOs underperform for investors. In Australia, 1994–2005, the difference between VC/PE-backed IPOs and other IPOs statistically insignificant.

The Australian Venture Capital Association Limited (AVCAL), in cooperation with Rothschild, reports that although non-PE-backed IPOs performed higher in 2015 than PE-backed ones, PE-backed IPOs higher results from 2013-2015. AVCAL argues that “PE-backed IPOs significantly outperform non-PE-backed IPOs after the first year of listing,” with PE-backed IPOs outperforming non-PE-backed IPOs by 23% inside a 12 months of listing.

Similarly, Deloitte argues that “private equity listing performance suggests that performance is much more positive than market sentiment reflects” and that $1 invested in each PE-backed IPO since early 2013 would have yielded an average return of 48% to end of 2015

Using the set of listings on the ASX for at least A$100 million reported by AVCAL (and their classification by whether the company is PE-backed), we are able to look at the average value of $1 invested in each PE-backed IPO versus $1 dollar invested in each of the non-PE-backed IPOs.

Thus, to avoid outlier PE-backed firms experiencing very positive returns, which could skew the results, the every day return is winsorized (limiting the outliers) and any return in excess of 100% is excluded (this adjustment actually causes distortion in favor of non-EP-backed IPOs).

The chart below, consistent with the chart shown in the AVCAL report, shows that PE-backed IPOs perform higher than their non-PE-backed counterparts. The same trend appears over longer two- and three-year horizons (although newer IPOs have not yet had the opportunity to provide such a long return history).

The findings show that it is incorrect to suggest that PE-backed IPOs underperform – while there are cases of underperformance, the average PE-backed IPO actually performs well.

Investors should consider seven aspects

This suggests that PE-backed IPOs do not necessarily underperform. But it’s clear that not all PE-backed IPOs will outperform either. Here are seven aspects related to post-IPO performance that investors should listen to:

1. Length of investment. The length of the PE fund’s involvement in the company will help indicate whether the PE fund has actually contributed to the company. In several poorly performing PE-backed IPOs (equivalent to Myer and Dick Smith), the PE fund only invested for one to two years. If at least a part of this time is also devoted to preparing the company for listing on the stock exchange, this may probably be insufficient time to fully transform the company. Of course, the time it takes to turn a company around will depend on its complexity, but a typical situation often requires several years of PE investment before an IPO.

2. Previous Litigation. VC and PE-backed firms that have recently been sued (or have had their portfolio firms sued) require further evaluation. The funds that were sued, yes difficulties in obtaining future financing and investors’ reluctance to invest in the fund itself could also be related to beliefs about how the fund can manage the firms it lists on the market.

3. The size of the sponsor’s portfolio. VC and PE funds that exist greater and invest more portfolio firms they have a tendency to underperform because they are too dispersed among portfolio firms, suggesting that their portfolio firms are underperforming.

4. The distance between the company and its sponsors. The geographical distance between a PE (or VC) fund and a portfolio company may raise concerns. For example, a fund domiciled abroad may face difficulties greater barriers to a successful end result.

5. Number of supporters. An organization with greater pre-IPO investor interest will likely have greater growth prospects and greater opportunities for different investors to pool their expertise to help the company. However, the advantages of getting more supporters are diminishing, with each additional supporter likely to have less ability to bring increasing advantages to the company.

6. Geographic diversification of sponsors. To some extent a sponsor who supported more firms in many industries and many regions he was able to gain extensive experience and connections that allowed him to transfer the portfolio company. There are limits, and over-diversification may cause the fund to focus too broadly. The fund’s history would help indicate whether such diversification has previously benefited the fund’s investments.

7. Continuation of the PE fund’s involvement in the company. A generally positive sign is continued PE fund involvement in the type of board positions or ownership interests (beyond the minimum time or legal amount required).

Essentially, while investors should at all times evaluate each IPO on its merits, there is no reason to avoid PE-backed IPOs themselves.