Private Equity Over the Years
The scale of private equity funds in the US has increased dramatically over the past decade. With that being said, many claim private equity backed Initial Public Offerings (IPOs) make for better investments with substantial returns post IPO. While this may have been true in the past years, PE backed IPOs are moving in a negative direction with various red flags that should not be underestimated. During the IPO Market’s 1Q, PE accounted for 8 of the 24 IPOs raising 4.6 bn, a 7% increase in proceeds from 1Q 2019. PE funds have picked up exponentially in the past decade with an estimated 2.4 trillion in current dry power. As PE grows in the financial world, so does its risks and influences on the IPO market.
In the period 2000-2010, PE accounted for 30% of all IPOs and demonstrated promising returns to investors with a 3 year buy and hold investment yielding an average of 7.9%. Conversely, venture capital based IPOs returned a loss of -12.9%. The shift of PE to VC-backed companies gained momentum in the 2010 decade as the decade received the name of “the age of venture capital”. Fast Forward to 2020, while private equity-backed IPOs have not slowed in deal size, they have certainly taken a hit in performance.
Recent Activity in the Private Equity Market
The most notable Private Equity (PE) sponsored Initial Public Offering (IPO) from this quarter was PPD, a leading provider of drug developmental services in the pharmaceutical sector. The biotech IPO was backed by private equity giant Hellman & Friedman which acquired the company in 2011 for a valuation price of $3.9 bn. After taking the company private and subsequent financial boosting, after 9 years, Hellman & Friedman returned to public markets in February 2020 at a whopping
valuation price of $13.4 bn. PPD shares debuted at an average price of $28.6 and now sit at a price of $16.79 a share. Currently, since its IPO, the newly public acquirer has returned -41.2%. While this is simply one IPO, recently, many buyout-backed IPOs have performed similarly with losses totaling over 20% since their respective IPOs.
PE vs. VC
While one cannot be sure what the specific reason may be for the poor performance of private equity in the IPO market, a few key characteristics are crucial to scrutinize. But, before I dive into the reasons why private equity is gaining a negative affiliation in the IPO market, I want to make sure readers understand the difference between private equity (PE) and venture capital (VC) based companies, as the media often intertwines the two. PE-backed companies are mature companies that have been previously acquired by a private equity fund. On the other hand, VC-based companies are companies that have received funding in their earliest stages by individual investors or VC funds before any form of revenue was generated.
Now, let’s talk about their strategies. The strategy behind PE funds is the idea of completely buying out a mature company that has an appealing valuation price (target company) and then once boosting its financials such as increased revenue or diminished expenses, selling the company for a greater valuation than what they purchase it for, ultimately creating a margin for profit. PE firms take around 3-5 years after an LBO (leveraged buyout) before selling and taking profits. VC revolves around the same idea; however, VC investors initiate a position in a company at an earlier stage and typically only sell their stake well after the company has gone public.
Exit Strategies
Note how the exit strategies between PE and VC are very different. In past years, studies have illustrated that investor-based leverage post IPO is strongly correlated to positive performance for new publicly traded companies. In other words, companies that retain their key investors after going public produce greater returns than companies that replace their core investment group. This study justifies why VC IPOs have surpassed PE in the past couple of years. Unlike VC-backed IPOs, PE investors view IPO’s as merely an exit ticket once they receive their desired valuation price. This results in IPO share prices plummeting as the company scrambles to organize a management team that has no prior experience with the company. Conversely, VC backed investors have no reason to flee as they benefit more from sticking with the company after going public. While this key difference between PE and VC is small, it should not be overlooked when comparing the two.
Pricing and Valuation
Another factor concerning buyout backed IPOs that contributes to poor post-IPO performance is its company’s IPO valuation. PE backed IPOs tend to be overpriced due to the firm’s investors wanting a greater valuation when filing to go public. Remember, PE firms seek greater valuations as that’s where the majority of their profit comes from. We all know a greater valuation means a more expensive price range for shares in its IPO, which ultimately hurts the stock as its intrinsic value lies a substantial 20-30% below its valuation.
As PE continues to produce increasing amounts of IPOs without substantially boosting post-IPO returns, the IPO market looks to continue its downtrend.
For further reading, I recommend checking out: https://www.toptal.com/finance/private-equity-consultants/state-of-private-equity