Dick Smith and Spotless create investor issues

Published at Dec 9, 2015, in Features

The issues of Dick Smith and Spotless highlight the problem of jumping into a Private Equity backed float writes Sam Green, advisor at options educator TradersCircle.

Beware buying shares in a PE float.

Private Equity firms seek to profit by buying underperforming companies to recapitalise and rejuvenate, before releasing these “new and improved” companies to the primary market.

The issue for regular investors is that these “new and improved” companies usually seem to maintain their capitalisations and profitability for long as it takes the Private Equity firm to sell their stake. In the recent cases of Spotless Group Holdings (ASX:SPO) and Dick Smith Holdings (ASX:DSH), this has left shareholders with drastically devalued holdings.

On Tuesday 1 December, Spotless Group announced that Net Profit would fall 10 percent in 2016. This was despite providing guidance, as recently as the 22 October AGM, that profit in 2016 would “materially exceed” 2015. This profit admission caused the share price to fall over 40% on the day.

These recent Private Equity IPOs will serve to further weaken investor sentiment, which was severely damaged by the float of Myer in 2009, leading to “a long hiatus in the IPO market” according to Julian Beaumont from Bennelong Australian Equity Partners.

Myer shares are currently trading at less than a third of their 2009 issue price.

However, despite the criticisms there are also stories of success from Private Equity IPOs. For example, Link Administration Holdings, which operates share registry and other financial services, was floated by Private Equity firms back in October; for an issue price of $6.37. Link shares are currently trading at $7.37.

Additionally, research from The Australian Private Equity & Venture Capital Association published in February, showed that for the 2013-14 period, PE backed IPOs outperformed non-PE backed IPOs since listing, returning 10.3% versus 7.0%. However, they concede that non-PE backed IPOs in 2014 outperformed PE backed IPOs, returning 13.7% versus 6.6%.

It appears that any outperformance is usually confined to the short term, with the research showing PE backed IPOs outperform non-PE backed IPOs by 26% over a one year period post listing, with returns broadly comparable to non-PE backed IPOs over 1 month and 1 week periods.

The issue for IPO participants is that Private Equity usually exits their holding as the business is being run as hard and as fast as possible, with costs cut to the minimum, choice investment of new funds and usually as business is experiencing a short-term boost. Private Equity will then sell the firm for the highest valuation possible, often leaving little room for further growth in capitalisation and potentially just as the short-term effects of Private Equity activity begin to wear off.

Usually the period of strong performance coincides with the escrow period of Private Equity held shares (a period after the float in which the majority of Private Equity held shares cannot be sold), with the end of escrow usually hailing the sale of said shares and the end of the business’s outperformance.

“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.”

There are also stories of PE IPO success, such as APN Outdoor (ASX:IPO) and iSentia (ASX:ISD), which are both trading significantly higher than their offer price AND their price at the end of their last escrow period.

Therefore, whilst there is justification to be additionally hesitant before buying into Private Equity backed IPOs (the mere fact that it is Private Equity backed does not guarantee the issue is a lemon. Instead, like everything, research, analysis and forward thinking are the key.

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