Can private equity and public investors reconcile?

In the 1984 pilot episode of Miami Vice, Sonny Crockett and Rico Tubbs tear through neon-lit Miami in a Ferrari while Phil Collins sings “I can feel it coming in the air tonight.” There’s little dialogue in a tense four-minute scene, punctuated by the song’s terrific transitory drum solo. Crockett stops off at a phone booth to ask his estranged wife, “It was real, wasn’t it?”, while Tubbs loads a shotgun for a showdown with a drug trafficker. The air is thick with suspense and anticipation.

Jump to today, and equity capital markets bankers can feel it coming in the air, but they’re not sure what “it” is. Banks have bulging pipelines of exciting IPOs, even after discounting the hype and hyperbole. But those same bankers know that after two years of deal doldrums, the higher-ups’ patience is wearing thin. The expected flow of IPOs last autumn dried up after a soggy after-market performance. The IPO boom of 2020-21 was real, wasn’t it? Or will 2024 be a reckoning?

Optimism is running high for an IPO resurgence. There’s pent-up demand from investors hungry for deals, and private equity and venture capital firms are keener than ever for a “liquidity event”. Throw in stock markets surging to near all-time highs, with inflation easing and talk of lower interest rates. Everyone is bulled up!

Amid the myriad sellside forecasts, one thing is (almost) certain: 2024 IPO volumes are poised to surpass the lacklustre years of 2022 and 2023. The question is whether the recovery suffices to sustain the hefty cost structure of equity underwriting businesses.

And for that to happen, private and public valuations must start to converge. According to MainFT last week, private equity sponsors have an “unprecedented stockpile of ageing deals” to exit, with their limited partners (ie end-investors) pressuring them to sell assets and return cash. But the current disparity is stifling deal flow, despite roaring markets and soaring indices.

Private equity investors and public markets are locked right now in a dysfunctional relationship that resembles a toxic codependency. Both sides need each other, and yet they seem to be working at cross-purposes.

A toxic codependency can be defined as (our emphasis) . . . 

a detrimental relationship dynamic where one partner consistently prioritizes their own needs over the needs of the other . . . The constant imbalance in meeting each other’s needs often leads to a sense of dissatisfaction and an unhealthy power dynamic within the relationship. This further exacerbates the negative outcomes experienced by both partners involved.

This sums up the dynamic between private and public investors. Each side is looking after their interests and believes the other side isn’t keeping their end of the bargain.

Private equity sponsors have never felt at ease with IPOs. Listings require long preparation time (typically 6-9 months), public investors demand lower leverage (which depresses returns), and a stock market float doesn’t provide a complete exit, requiring subsequent stock sales after a lock-up. And once floated, the asset has to be marked to market, subjecting reported valuations to wild fluctuations. It’s discomfiting for financial sponsors to tie their fortunes to such an emergent, complex and untameable phenomenon like the stock market.

The IPO marketing process adds another layer of unease. For one thing, there’s no one to negotiate with: you are dealing with an amorphous blob beholden to nothing and nobody. Equity fund managers may not understand the investment case and sometimes can’t be bothered to do the work. And some private owners suspect (wrongly, in my view) that investment banks are minded to underprice an IPO to favour their investor clients.

Finally, private equity sponsors believe they have poured blood, sweat and tears over several years to improve their portfolio companies. It’s natural to want to reap the rewards before handing off to hedge funds and long-only investors. In any case, their limited partners expect private equity to maximise returns, not leave free money on the table for third parties.

Buyout firms think public market undervaluation is so endemic that they have been taking quoted companies private, in some cases just a few years after they had floated on the stock market. Last week’s announced take-private of Swedish software group Byggfakta at 39 per cent below its 2021 IPO price is only the latest of a long list of such transactions.

In private equity’s ideal world, they would sidestep public markets. EQT, for example, is considering selling stakes directly to its limited partners, bypassing what its CEO dubs the “dysfunction” of stock markets. Other private shareholders have latched on to other ideas, such as merging with SPACs, to regain control over what they see as an unruly and broken process that deprives them of agency right at a crucial juncture. In any case, financial sponsors have several ways of unloading their investments without putting themselves at the mercy of the public markets, for example by selling to an industrial company or to another private equity firm.

But an IPO remains a key exit channel: if nothing else, it provides pricing tension versus M&A. You can’t have a credible dual-track — ie a parallel process of an IPO and private sale via auction — if the equity market avenue is closed. Moreover, there may not be a strategic investor to sell to, or trustbusters, like the “meddling kids” at the ultra-interventionist Federal Trade Commission, might throw regulatory sand in the dealmaking gears. And continuation funds and assorted financial engineering such as net asset value and margin loans have limitations and complications. Private equity needs robust public markets even if no assets are floated.

The hitch is that public investors are wary of flotations from financial sponsor-controlled firms. IPOs of all types have underperformed, and studies suggest that private equity-backed IPOs perform no worse (and arguably better) than the broader spectrum of IPOs. But that’s not the perception.

It’s more of an emotive point than an empirical one: investors chalk up successes to investing nous but harbour a long grudge when an IPO trades badly. UK fund managers still complain today about the London float of retailer Debenhams from back in …2006! Yes, financial sponsors usually hold a post-IPO residual shareholding for a while, but that is cold comfort when a big slug of stock has been sold at IPO at a flagrantly inflated price.

Investors won’t boycott an IPO from a private equity firm. They are paid to manage money and make money, and that means they want to have a look at deal flow. They also know that sponsors often acquire the best private assets. But they also reckon that sponsors tend to buy low and sell high and have a significant informational advantage. After suffering stomach-churning losses on the most recent round of IPOs, investors have no appetite to be holding the (barf) bag this time.

In the Miami Vice pilot Crockett and Tubbs don’t like each other at the outset. But they bury the hatchet and [SPOILER ALERT] team up to take down a dangerous drug kingpin. Similarly, public and private investors can overcome their differences. The question is whether strong equity markets have created enough space for IPOs to be priced at a discount to their fair value whilst still allowing private equity to meet performance hurdles.