The party's over before you get there

Be wary as private equity backed IPOs may be about to return


This article first appeared in Aimzine, www.aimzine.co.uk 
 
With some reluctance, I went on my first ever cruise this month. My reluctance wasn’t the fear of being on a large piece of floating steel in the calm waters of the Med for a week, but rather the thought of being captive in a mobile hotel with a very large number of Americans. I suspect that like most Brits, there are certain things about America that I love such as its energy, optimism and vibrancy but there are other things which cause me, at best, concern and at worst total dismay. Putting aside serious matters such as the possibility that a Soccer Mom might become the next President, the unquestioning support by successive American governments for brutal dictatorships and the huge amount of US government debt which will one day cripple the global economy, my greatest concern and dismay right now is over the import into the UK of the US concept of the Prom Party. This phenomenon is growing massively in the UK with more and more schools every year organising these over-glamorised school-disco celebrations of insignificance.

The Prom Party is good news for some people though; most notably retailers. Rob Templeman, soon-to-depart Chief Executive of Debenhams says that for his company it is now the second largest sales peak of the year, second only to Christmas. That’s probably little comfort for his shareholders who have seen the Debenhams share price fall from 195p at IPO in 2006 to around 70p currently.

Large dividends
The IPO price although at the bottom end of the range at the time still delivered a good return for the private equity firms which had originally taken Debenhams private in 2003. CVC, Texas Pacific and Merrill Lynch tripled their £600m investment during the three years the company was in private equity ownership, partly through selling properties, increasing the company’s debt and taking out large dividends.

Since the company listed on the stock exchange with shares being bought by reputable institutions there have been numerous questions raised about the growth prospects for Debenhams, even before gloom descended on the high street. Strong sales growth was essential to service the debt that had been foist on to it by the private equity firms, as well as to meet the largely fixed costs of a retail business. However, that sales growth hasn’t come through with the last reported figures showing like-for-like sales excluding VAT being down by 1.5%. Moreover, after repeated profits warnings and dividend cuts the Chairman admits that the current outlook is “no real change in consumer confidence”.

So for institutional shareholders who bought shares at the IPO it has been a fairly torrid time made worse by knowing that the previous shareholders managed a phenomenal return on their investment.**

I was reminded of the Debenhams saga during the month as another private equity backed clothing retailer New Look revealed that it wouldn’t be seeking an IPO in the near future. Looking through the results they announced for the year to March 2011 that was hardly surprising as like-for-like sales were down by 5.5%. This downturn in revenues contributed to a fall in Operating Profit from £162m last year to £98m; quite a problem when the company has net debt of over £1 billion on its balance sheet. No doubt though that the current owners of New Look, the private equity firms Apax and Permira, will do what they need to do to prepare the company for IPO at some point in the future, and pass the problems on to some nice-but-dim fund manager.

Successes and failures
Of course, over the years, there have been some cases of private equity successfully improving performance in acquired businesses, including Halfords, the Automobile Association, Homebase and RHM. There have of course been notable failures, the most spectacular being the imminent failure this month of the care homes business, Southern Cross, previously owned by another private equity group, Blackstone. Southern Cross provides a further example of property sales followed by increased debt and massive dividends for private equity groups, ending up with an IPO, although in this case of course its failure has more serious consequences for its customers than a high street retailer disappearing into receivership.

Most recently this month, Aviva announced that it was selling its RAC roadside rescue business to the private equity group Carlyle for £1 billion. The managing director of Carlyle, Andrew Burgess, said he saw a “strong longer-term potential to grow the business by investing in new and innovative financial services offerings, such as motor and household insurance”. No mention of course of selling properties, increased debt or huge dividends for Carlyle. However, bank debt is becoming more available for these types of deals and is likely to be used in the RAC deal; infact JP Morgan which ran the sale process for Aviva is also making finance available for the successful bidder which will put debt on to RAC’s balance sheet of up to seven times the company’s operating profit.

What is certain is that at some point RAC will come back to the public markets along with other PE-backed companies such as Merlin, the owner of tourist attractions including Madame Tussauds, Phones4U, and numerous other companies being lined up for IPO. Ernst & Young, a leading accountancy firm estimates that there are fifty private equity backed companies intending to IPO in the near future and looking to raise around £10 billion in aggregate.

The question for investors both institutional and private is if by the time they get on board the party will still be going on or whether it will be about to fizzle out leaving the new shareholders to do the clearing up.



** For anyone wanting to understand the fascinating case study of Debenhams from its purchase by private equity in 2003 through to its profit warnings and dividend cuts as a public company, contact me on the email address below for an excellent academic research report.