Private Equity IPOs: More Than Meets the Eye

There is both more and less than meets the eye with IPOs of private equity firms. They have more reasons for selling than most people know and they are not selling what many people think they are selling. Caveat Emptor.

Our first impression, expressed in our March 26 article “The Private Equity Party Might Be Over” may have been too simple. We and others have suggested that the IPO flurry may suggest the end of a private equity boom. We still hold that the flood of related equity IPOs may create price dampening supply/demand effect on shares of public private equity companies, but maybe “end of party” is not the whole story.

American Capital Strategies (ACAS) with $11 billion AUM has been public for a while. Fortress (FIG) with $30 billion AUM recently went public. Blackstone ($50 billion AUM) is preparing an IPO. Apollo ($16 billion AUM) is reported to be actively considering an IPO, and a potential pack of lemmings may not be far behind.

Commentators suggest something like $10 billion AUM is necessary to join the IPO procession for private equity firms. That puts companies such as these in the potential “me too” category:

• SAC Capital ($12 billion AUM)
• Och-Ziff Capital Management ($?? AUM, but they are on lists)
• Citadel Investments ($13 billion AUM)
• Perry Capital ($11 billion)
• Angelo-Gordon ($12 billion)
• Avenue Capital ($13 billion).

What are the IPOs actually selling?
The IPOs are of private equity operators and not of the private equity investments they control. The IPOs are selling the general partnership interests in the limited partnerships that buy and own the businesses we read about being privatized in the headlines. The general partnership interest consists of an annual fee and a carried interest in the underlying private businesses owned by the limited partnerships.

The carried interests provide the general partner with a percentage of the gains on sale of the businesses owned by the limited partnerships. That’s not bad or good – it’s just not the same as being a private equity investor as so many institutions and high net worth individuals have become today.

So if it is not the top of a cycle, what might be going on?

Individual Life Cycle Issues: Founders of these companies need a way to liquidate their holdings as their careers come to a natural end due to age and success. They may want to be more diversified. They may want to become more philanthropic with cash donations. They may want to distribute cash wealth among family members. They may not want to have all their eggs in one basket when they phase out of management roles.

Taxation: Congress is apparently considering changing the way “carried interests” of general partners are taxed when sold. If the taxation of those carried interests could go from capital gains to ordinary income, that would approximately cut the tax benefits of those carried interests in half.

However, if those carried interests were monetized now in an IPO, the founders can take capital gains on not only their carried interests, but the present value of future fees which are currently ordinary income. That would leave the IPO investors exposed to ordinary income on gains from carried interests, but that is another story.

Interest Rates: Cheap money has fueled private equity acquisitions for years. Some people fear an end to cheap money is approaching. If that is the case, the fuel tanks will be lower or the fuel will have lower octane. Either way, the growth rates and profit margins on leveraged-buyouts (pardon the ancient terminology, but that’s that whey are doing) will decline. That is a sort of end of party scenario.

Competition: It is also possible that the shrinking field of qualified prospects to privatize and the swelling field of private equity players may be increasing competition in such a way that growth and/or profit margins are at some risk of leveling or declining. That too is an end of party issue.

What’s the message?
For private equity firm owners, it's probably wise to go public. For investors, keep your eyes open before you jump in. The risks are substantial. They aren’t selling this stuff to provide you opportunities. They’re doing it for themselves. Make sure you know why they don’t want the shares before you decide why you do want the shares.

Full Disclosure: At the time of this writing author owns ACAS.