30 Mar 2017

Finding gems amongst lemons - private equity backed IPOs

Avoid hot stocks in hot industries. Great companies in cold, no growth industries are consistent big winners. - Peter Lynch

At the start of the IPO season in New Zealand in 2014 we wrote an article titled "IPO Season - Look Out for Lemons".  In it we discussed the information asymmetry that occurs between the seller and the buyer during a market listing, and how that asymmetry might affect the efficient functioning of the market.  It is our opinion that plenty of lemons get floated, but occasionally something of quality comes up.  Often, you can invest in a quality company at a pretty reasonable price, if you can pick it, because of the general risk-of-it-being-a-lemon discount that the market places on IPOs.  Click here if you would like to read the article. 

In that article we also listed several red flags to consider, one being whether the seller was a private equity firm.  Private equity businesses often get bad press.  Business founders can be cautious about selling to them and the market is cautious about buying from them.  When dealing with private equity businesses you are dealing with professional investors and you are generally unlikely to get a bargain. 

But not all private equity businesses are trying to dress mutton up as lamb in the hope they can list it and depart before anyone realises.  Some provide a very useful function, providing founders a way to exit a business before is ready to be listed and building scale and institutional infrastructure, ultimately listing a much stronger business.  This must be a better option for New Zealand than losing the business to a large international corporate.

We are fortunate in New Zealand that many of the private equity firms are of this type.  Ross George of Direct Capital was recently quoted discussing their simple strategy, stating "Most of us just try to invest in good businesses and grow them." New Zealand is a pretty small market which also makes it difficult for a private equity company to float a lemon, as few investors will come back with open arms the next time they list something.

However, in Australia, the market is deep enough for the other type of private equity company to exist and it is important to be wary.  A notable example is the private equity backed IPO of Dick Smith, backed by Anchorage Capital. It ended in significant losses for initial investors and was dubbed by Forager Funds Management analyst Matt Ryan as "one of the great heists of all time".

However, not all private equity floats will be lemons. In fact, it is our opinion that that you might occasionally be able to buy a quality business at a good price given the general level of scepticism of the seller by the market.  Associate Professor of Finance at UNSW Business School, Mark Humphrey-Jenner, has identified seven factors associated with the private equity firm and the post-IPO performance the float that investors should look for:

1.    Length of investment by the private equity firm – longer the better.

2.    Prior litigations – bad.

3.    The private equity firm’s portfolio size – less the better.

4.    Distance between the company and the private equity firm – closer the better.

5.    Number of backers – more the better.

6.    Geographic diversification of the backers – more the better.

7.    Continued involvement in the company – good.

We think we have found a good one.  IVE Group is well-run printing business that was listed on highly undemanding multiples in 2016. It is not hard to see why at first glance.  The print industry is in decline and IVE was formed when Wolseley backed CaxtonWeb to acquire the Australian operations of the failed Blue Star Group, and then acquired other print businesses before coming to market.  It also didn't help that IVE first tried to list at about the same time that Dick Smith unravelled.

However, digging a bit deeper things get a little rosier.   Wolseley is a boutique private equity firm that is more like the New Zealand style.  The IPO scores seven out of seven in Mark Humphreys’ above check list.  Wolseley partnered with the Selig family to purchase and reconstruct the business and both Wolseley and the Selig’s remained material holders of equity after the float.  The executive team is deep, experienced and highly respected in the industry. 

While Wolseley has now exited the Executive Chair, Geoff Selig, remains well aligned with shareholders with $AUD20m of his family's wealth tied up in shares of IVE.  While the print industry is in decline, IVE operates in segments that are more stable, are duopolies or where it is a dominant consolidator of small and fragmented competitors.  Good printing businesses remain great generators of cash.  They fail when too much debt is employed.  We believe that IVE Group will surprise the market over time with the robustness of its earnings and cash flow and if it does it will not remain priced at its current low multiples.