As stockmarkets reach new all-time highs, several companies that previously underwent leveraged buyouts (LBOs) are in the process of listing. This includes a number of firms that pulled initial public offerings (IPOs) last year in difficult market conditions. For example, US flooring retailer Floor & Decor, which floated on 27 April – and enjoyed an eye-catching 44% leap in its share price on the first trading day – had originally pencilled in its IPO for this time last year.
Supporters of private-equity-backed IPOs regularly point to academic research that suggests they tend to perform better than other IPOs. Yet there are significant shortcomings with such claims. IPO candidates differ in many ways, be it in their stage of development, the sector or geographies they operate in, or even the size of the float. There is little sense in comparing the private-equity-backed IPO of car-hire specialist Hertz with that of the early-stage, loss-making, fast-growing internet firm Snap, especially given how immature the latter’s business model is compared with Hertz’s 80-year-old operations.
What is more troublesome is that over a longer period (12 months beyond the IPO), the performance of private-equity-backed listings deteriorates. This is partly because the owners have sold out by then, so there is little incentive for the banks that underwrote the float to keep supporting the stock. Hence, by that stage, the initially inflated price/earnings (p/e) multiple declines to be back in line with comparables.
For example, Hilton Hotels listed in the US in December 2013 on a p/e ratio of 48. Three years later, the p/e was below 15, while the group’s balance sheet remained bloated with debt. Even valued on an enterprise value to earnings before interest, tax, depreciation and amortisation (EV/Ebitda) basis, which takes out the negative impact of debt expense, Hilton’s multiple stood at about 12 times on 31 December 2016, compared with 20 times in 2013.
It is not obvious why investors thought the Hilton IPO was going to be a good deal. Even at the peak of the real-estate bubble in 2007, its owner, Blackstone, had paid $26bn for the chain ($5.6bn in equity and the rest in debt), or 15.5 times that year’s Ebitda. Why should Hilton warrant a higher multiple on listing, while the economy was still recovering from the Great Recession? Still, bolstered by its successful exit, Blackstone decided to treat the market to another hotel asset: La Quinta, a mid-market North American chain. In April 2014 the group listed at $17 per share, or 14 times Ebitda. The stock now sits below $14, on less than ten times Ebitda.
The tendency for LBOs to be overpriced on listing is widespread, and where America leads, the rest of the world follows. In the UK, Saga, Poundland, and Pets At Home all listed in early 2014 at a p/e ratio of around 30. Within two years, all were quoted at 15 times net income or less. But even setting aside overvaluation, many LBOs can be poor candidates for a listing, either because they are overleveraged or due to their weak fundamentals.
Such companies should probably not float, but an IPO offers the financial sponsors a way out, thanks to the complicity of institutional investors. In the UK, estate agent Foxtons and tool-hire specialist HSS had several profit warnings in the first two years post-IPO. Within one year of floating, HSS was worth half its listing price, and Foxtons saw its shares lose 40% in 18 months.
People who argue that private-equity-backed IPOs are performing no worse than other listings are missing the point. If claims made by financial sponsors that they are superior asset managers were correct, their portfolio companies would experience fundamental improvement under their stewardship. Their stronger post-IPO performance would be undisputable proof of this. The evidence provided by public markets suggests otherwise. Buyer beware.
Sebastien Canderle has more than two decades of experience in private equity and the financial sector. He is the author of The Debt Trap: How Leverage Impacts Private-Equity Performance