How to Earn IPO Profits From the Inside

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 |  Includes: BX, KKR
by: John Tobey, CFA

No, you don’t have to buy private shares of Facebook. There is a more diversified, less risky (and possibly more profitable) approach.

Not since the 1960s have private investors had access to IPO gains from the issuer’s side. Here’s the story:

In 1966 (a down market), I was looking for stocks showing strong upturns when I spotted the former closed-end fund, American Research and Development Corporation (ARD). Although the stock’s action was impressive, I didn’t buy. I thought a fund couldn’t produce the returns that a single company stock could. But I was wrong.

ARD held venture capital and private equity positions (ARD description). Among them was Digital Equipment, which was publicly offered in August 1966. ARD earned many times its investment cost. That was then followed by the lucrative IPO period in the 1967-1968 bull market. ARD was an outstanding investment for private investors.

Today’s similar opportunity

Virtually all venture capital and private equity firms remain private. They operate with their own money and/or funds invested by institutions. (Industry description)

There are two exceptions: Blackstone Group (NYSE:BX) and KK&R (NYSE:KKR). Both have public shares. BX’s IPO came at the market highs of June 2007. KKR’s IPO followed a circuitous route through Euronext in October 2009, then to the NYSE in July 2010. (Unlike ARD, both are company shares, not closed-end funds.)

The opportunity looks big

Bloomberg Monday afternoon described well the coming opportunity – how the venture capital/private equity firms are poised to cash in beginning this year (Buyout Firms Offering LBOs to Flood U.S. IPO Market”). Importantly, BX and KKR should be major beneficiaries.

More than half of the U.S. initial public offerings planned for this year are from private equity firms as KKR & Co., Blackstone Group LP and Carlyle Group try to sell some of their biggest leveraged buyouts.

BX and KKR, compared

The two firms are different. Blackstone is diversified with many other investment activities. KK&R is more specialized, focusing primarily on the private equity business. Their websites provide a good overview of their businesses: BX KKR.

My preference is KKR

My desire is to pursue the potential returns from an active IPO market. Whenever there is an IPO lull, like the one we have witnessed, the initial IPOs tend to be for high quality, more mature companies. There is generally strong demand for these companies, and that kicks off the bullish cycle.

Therefore, I prefer KKR, with its more focused approach. In addition, two of the founders (Kravis and Roberts) are still active in the business.

Notice, too, that the stock price has been rising faster than the stock market over the past two months…

click to enlarge

Click to enlarge

One potential IPO example: Toys R Us

Last September, this article appeared: “Toys R Us Invades the Mall for the Holidays.” I hadn’t thought about Toys R Us since KK&R and two other firms bought it in 2005 (article). Reading through, I was impressed by the company’s strategies (confirmed by further research). Then, the article’s conclusion caught my eye and got me thinking about the coming opportunity:

The privately held company said in late May that it plans to go public by raising as much as $800 million in an initial public offering that would be one of the biggest retail IPOs in years.

But on Wednesday, [Toys R Us Jerry] Storch declined to say when an IPO might occur.

’That’s not something that we can predict, it depends on a variety of factors including the health and stability of the markets,’ he said.

That IPO would not only mean big bucks for KKR and its shareholders. It would also provide an attractive IPO example from a well-known company – just the thing to spur investor interest.

So… There could be an active IPO environment in 2011. This would likely mean large gains from quality, mature positions at venture capital/private equity firms. We should be able to participate from the inside through BX and KKR.

Disclosure: I am long KKR.