What to do with IPO's?

September 2016 Interest Piece

The most common way for a private company to be listed on a stock exchange is through an Initial Public Offering (IPO). There are a number of reasons why companies come to the listed market. The first, and typically the most attractive reason for us as investors, is that some businesses find themselves on a path of growth and opportunity that requires additional funding. These IPO’s are often a great chance for us to invest into exciting new companies, as long as they are sensibly priced.  Another motivation though, and one that we need to be more careful about, is where the private owners of these companies look to an IPO as a mechanism to sell their position. Where this process occurs we need to be particularly careful about investing because there is always an unfavorable asymmetry in the information available. It is important to remember that  a public market investor almost always know less about a business  than those who currently own it, work in it and are now selling it.

One of the reasons that we are writing on this topic today is that as investors we are currently being asked to consider a large number of IPO’s in Australia and, to a lesser degree, New Zealand. This isn’t very surprising because, after the strong run that share markets have enjoyed over the past 7 years, the value that vendors can now achieve through selling their privately held businesses to the listed market is now often far higher than trade buyers are willing to pay. The appetite for investors to participate is also currently high because of their recent positive experiences in shares. When we consider IPO’s it’s difficult to prescribe a reliable framework of black-and-white rules. For example at the moment it is commonly accepted wisdom that investors should avoid floats coming from private equity vendors. The perception is that private equity buys a business then excessively leverages the balance sheet, starves new initiatives of capital and strips costs from operations to an unsustainable level. The private equity operator then, the theory goes, turns to the public markets to exit their position by proposing that the company’s recent profit experience is a reliable platform for future earnings to be driven from. The outcomes have often been painful for the public markets.

The case study for bad Private Equity IPO’s in recent times is the failure of the electronics retailer, Dick Smith. This was a situation whereby the private equity group, Anchorage Capital acquired Dick Smith for less than A$100m in 2012 from Woolworths (although Anchorage only put $20m of equity into this transaction). Anchorage then floated the business onto the Australian stock exchange the following year for A$534m before seeing it collapse into administration in 2016 owing A$140m to secured creditors. This situation was a classic example of the challenges that investors had previously leveled at this vendor set.  The Dick Smith IPO has been the subject of a Senate Enquiry.

While some investors have had terrible experiences investing in private equity backed IPOs it is worth noting that many private equity floats have performed well. Indeed, a report compiled by Deloitte highlights that the Australian performance of Private Equity backed IPO’s between 2013 and 2015 was on average almost 14% greater than the weighted average performance of the Australian stock market (S&P/ASX200G) over that period. It is also worth noting that during that time, 8 of the top 10 IPO’s in Australia were Private Equity sponsored. Relative performance since then and over longer time frames has been less positive but the point remains valid that Private Equity ownership does not always determine a poor outcome. A number of progressive steps have been made in developing the relationship between public-market and private-market investors. First and foremost, the public markets, having become increasingly discerning of the traditional challenges that were associated with private equity opportunities, and have forced the hand of quality. It is now with a more forensic approach that the public markets consider capital structure, required capital investment and earnings sustainability. It is also worth noting that the tolerance of the public markets for private equity vendors to exit all their exposure in these listed businesses is much lower. We now expect the sellers to remain involved in the business for longer to support the achievement of prospectus obligations.

We at Devon always take a very conservative approach to the assessment of IPO’s because they simply lack the long-dated public market disclosure that exists with other investment opportunities. That typically results in us foregoing more IPO opportunities than we participate in. But it is worth highlighting again that this is an opportunity set that is well worth considering and one that we have made a lot of money from for client portfolios. .As the bull-market nears its 7^th year the quality of many of the proposals that we are seeing is lower and we are rejecting more of them. However, at the risk of sounding clichéd, there will be diamonds amongst the rough. It was only 4-months ago for example that we invested into the public market listing of GTN Limited. This high quality industrial business came to us from a private equity owner and although it wasn’t widely supported by institutional investors in NZ or Australia we recognized it as an exciting opportunity. The IPO price was A$1.90 per share but today the stock is now trading above A$3.00 per share. This experience is more the exception than the norm but with global equity markets trading at elevated levels it is great to see that opportunities for strong performance still exist.

Slade Robertson – Portfolio Manager