IPO shutdown forces PE firms to seek new exits

Confronted by a near-shutdown in IPO markets, private equity firms are having to source other investments with better exit prospects, with secondary market buy-outs and dividend recapitalisations tipped as key options.

Speaking about the outlook for Asia-Pacific private equity at an event organised by Ernst & Young and Remark last Thursday, PE executives cited examples of Chinese firms delisting from the US via privatisation as proof that IPOs could no longer be relied on as a viable exit for general partners, at least in the near term.

Battered by a declining share price, last August Chinese digital advertising firm Focus Media announced it was delisting from the New York Stock Exchange, through a $3.5 billion privatisation bid from PE players including Carlyle, FountainVest Partners and others.

That came after Toronto-listed lumber firm SinoForest and Nasdaq-listed software firm Longtop both became embroiled in accounting scandals. The perception among international investors was that these Chinese firms won their overseas listings via fraudulent accounting practices, by beefing up their valuations.

“With companies such as SinoForest and Longtop…[interest] from US investors for Chinese equities has been limited and is not expected to return anytime soon,” notes Tim Gardner, partner at Latham & Watkins.

In December, the Securities and Exchange Commission also began proceedings against the Chinese arms of accounting firms E&Y, KPMG, PricewaterhouseCoopers, Deloitte Touche Tohmatsu and BDO for failing to produce auditing work related to their US-listed, China-based clients under SEC investigation for suspected accounting fraud.

Now if PE firms are looking to invest into Chinese companies, for example, they are required to look at exits other than the US IPO market. And this is true globally.

North America saw just 187 new listings last year, from 301 in 2011 and 314 in 2010, according to data provider Dealogic. Only one Chinese company Launched an IPO on Nasdaq and one on the New York Stock Exchange last year, from 16 combined in 2011 and 42 in 2010. By volume, North Asia saw 262 IPOs last year, down from 464 in 2011 and 624 in 2010.

Amid the IPO shutdown, Gardner notes that the low interest-rate environment in the US has led sponsors to show a willingness to subscribe to bonds issued by firms with PE investment.

These companies are using the bond proceeds to repay their PE company shareholders – called a dividend recap. This process has become prevalent in the US in particular in recent times.

“Dividend recap is an interesting way for sponsors to take money out of the company [in the US]… it would be interesting to see whether we would see more [globally],” says Gardner.

But the practice has also proved controversial because the dividend payout is done at the expense of increasing a PE portfolio company’s leverage, which could lead to a credit rating downgrade.

Lucian Wu, managing director of Paul Capital, says he sees secondary-market buyouts as more relevant to Asia, with that market having grown in size to $20 billion a year, from near zero in 2007.

He agrees that the chief obstacle impeding international capital being deployed into Asia’s PE funds has been the difficulty of exiting investments.

He notes that the Volcker Rule has limited the alternative investments of US banks to 3% of their capital, making it more difficult for PE funds to raise capital, given that banks have traditionally been big PE sponsors.

He points to one secondary deal that Paul Capital completed four months ago, a $400 million buyout of a PE portfolio which included a team from Bank of America-Merrill Lynch.

Paul Capital then spun off the so-called captive team, or those bank employees who had managed the assets, and let them manage the assets separately after the buyout.

“We helped the [captive team] to build a new platform, so they become an independent team managing the portfolio assets,” says Wu.

Paul Capital has invested in 20 such captive spin-outs, and Wu adds that he is expecting more of these divestments from banks.

“We have been getting a lot of calls from banks’ captive teams sitting in these institutions looking at the future for themselves…we expect this to continue in the next three to five years,” adds Wu.