The Best Way to Go Public is Private

By Emma Trincal, Senior Financial Correspondent

Friday, July 27, 2007

NEW YORK (HedgeWorld.com)—Alternative investment firms planning on going public may have to review their strategy given the market turmoil and the current credit and stock sell-off. Rumors were circulating in news reports today [July 27] that Kohlberg Kravis Roberts & Co., the buyout giant, may be pulling out of its initial public offering.

There is another alternative, some market participants suggested. Rather than going public, IPO candidates could instead decide to access institutional capital through the private market. One way to do that is to conduct an initial equity offering via a private placement—also called the 144A market—which issues unregistered securities to a small circle of elite investors.

"Anyone considering an initial public offering in order to sell shares of themselves to institutions is well served doing it with a 144A structure," said Rick Hendrix, president and chief operating officer of FRB Capital Markets, an Arlington, Va.-based subsidiary of Friedman, Billings, Ramsey Group Inc., and a placement agent of domestic 144A equity.

So far, two large managers have announced this month their plans to go public: Those initiatives are a direct attempt on the part of those firms to compete with two firms that have already hit the public market: Fortress Investment Group LLC

Choosing a very different path, Apollo Investment, the U.S. buyout firm, is considering selling $1.1 billion worth of its own shares on the 144A market. Its underwriters are Goldman Sachs, Credit Suisse and JP Morgan, according to a bank executive. The model this time was Oaktree Capital Management LLC, a hedge fund that initiated the trend in May using a new private market created by Goldman Sachs and called GSTrUE. Apollo will also use GSTrUE, this executive said.

For some people, such as Mr. Hendrix, Apollo has chosen the right approach. "144A offerings offer a much quicker execution. You can access the same institutions than you would via an IPO but faster," he said. Mr. Hendrix may be preaching what he sells, but he is not alone in thinking that the current roller coaster in the market may lead investors planning an equity offering to switch from the public to the private markets.

For Francis Gaskins, IPO analyst at IPODesktop.com, a Los Angeles-based research firm, private equity and hedge fund firms in the pipeline for their own IPOs should either completely pull out of the market or seriously consider a private placement.

"KKR and Och-Ziff missed the window," Mr. Gaskins said. "They will have to do it on a private basis. The market has changed. If they could do it public, they would. But I think they'll have a harder time doing it."

"It's possible that KKR is considering a 144A deal," Mr. Hendrix said. "It would make a lot of sense for KKR or any other firm that want to access institutional capital to do it this way."

Given the current market conditions, firms on a roadshow seeking to sell stakes of themselves to investors need to be in a position to make the best pitch they can. Private offerings give them such opportunity, Mr. Gaskins said. "On a private deal, the company can be very clear about their growth plan and give many details, such as their earnings. They can't do that with the SEC," he said.

Apollo so far has retained attractive investors: An investment arm of the Abu Dhabi government and the California Public Employees' Retirement System, Sacramento, have already made direct investments, said the executive familiar with the Apollo transaction. Apollo is on a roadshow and its prospectus is circulating among a limited number of very large investors. Apollo declined to comment.

The current fear in the market around credit and leveraged buyouts could justify the need for quiet offerings. And whether those fears are founded or not, the climate overall is not optimal for the valuations of private equity IPOs.

"The market is jumping very quickly to conclusions. Yes, credit may be becoming more expensive, but it's not the death of the LBO era," said Mr. Hendrix.

It could simply be that we're seeing more volatility because the market has been used to cheap money for so long, he noted. "The market has to find its new level for the cost of credit to be re-priced. When it does, private equity firms will adjust the prices they pay for their deals and will continue to be successful. They may not use as much leverage, but they will still generate good returns," he said.

Meanwhile, the market is tumbling. For the second day in a row, the Dow Jones was down today [July 27] by 200 points, following a 300-point loss for the day before amid credit fears. With yields widening, many, such as Bill Gross, Pacific Investment Management Co.'s bond manager, are already predicting the end of the golden era for private equity moneymakers.

The junk bond malaise was evidenced this week when bankers postponed a $12 billion sale to complete Chrysler's purchase by buyout giant Cerberus Capital Management LP. With spreads wider, especially for leveraged loans and junk bonds, the economics of taking a company private may not be as good as they were only a few months back.

And the more skittish the market, the less sense it makes to go public, said Mr. Hendrix. "With a private placement, the press is not going to spend a lot of time focusing on the transaction. You can do it more quickly in a more controlled environment. Big institutions have all seen choppy markets and they are not afraid of market swings the way retail or small investors are," he said.

The argument the most often cited in favor of private placement—one that holds true regardless of the market environment—is that issuers on the 144A market do not have to file with the Securities and Exchange Commission. They can only sell to a limited number of sophisticated investors called QUIBs (qualified institutional buyers) with at least $100 million of investable assets. But they skip the regulatory scrutiny and get to speed up the deal process.

Because the number of buyers is limited in a private placement to 100, the perception is that deals are often priced at a discount when compared with IPOs.

"This is not necessarily true," said Mr. Hendrix. "For brand names, there could be a modest [discount] or no discount at all," he said. The best evidence was the Oaktree deal he said, which did not price at a discount when compared to Fortress.

Private placements offer another advantage: a quiet shelter from the turbulence of a heated tax debate in Washington. As Congress discusses bills aimed at almost doubling the tax rate of private equity partnerships, issuing shares on the private market offers the benefit of avoiding the added tax burden. So far, the proposed legislations only target publicly listed vehicles, not private partnerships. And so it pays to remain private.

What seemed like a marginal option when Oaktree announced its private issuance of shares in the spring, followed by Apollo this month, may now look like the only alternative. In fact, GSTrUE is such a successful initiative on the part of Goldman Sachs that the idea is almost certainly going to be imitated. A Wall Street executive said this is already the case, pointing to several firms he declined to identify other than saying that one of them is Lehman Brothers, which is currently conducting talks to create a consortium capable of competing with Goldman's 144A trading platform.

The other trading platform in this market is FBR Plus, a system offered by FBR. FBR has raised more than $11 billion in 39 private placements over the past five years. Mr. Hendrix said he gets a lot of calls from private equity firms inquiring about how to sell their own shares on the 144A market.

Candidates for hedge funds or private equity IPOs are not in the best position to conduct their offerings now. But market conditions can change and firms such as KKR and Och- Ziff still have time to think about their announced plans. Their respective IPOs, announced this month, are unlikely to occur before September since it usually takes at least two to three months for a deal to occur from the date of the initial filing to the actual offering.

For now, the obstacle is the debt market and what some foresee as the end of a decade of cheap credit. Another one is more structural: the scarcity of targets for LBOs is taking its toll on private equity firms looking for good valuations. "The supply of good deals has been picked over," said Mr. Gaskins. As a result, he said, private equity firms have been going after big brands such as Hilton Hotels Corp., Chrysler or First Data Corp. "They can't be magicians on those companies that already have institutions that own those stocks. It's hard to turn those big companies around and sell them at a higher price to institutional investors who are already owners of those shares. I don't get it," Mr. Gaskins said.

So if the economics of the industry are becoming less attractive, why would private equity firms persist in selling shares of themselves whether they do it publicly or privately? Today [July 27] shares of Blackstone dropped by 22% since the June IPO. During today's intraday trading, Fortress's shares fell below their IPO price and closed at $19.50, down by almost 50% from their $37 high. Will this dissuade the newcomers from jumping into the IPO fray?

"They want the liquidity. They need to do it to stay competitive. But part of it is driven by their egos. If Fortress and Blackstone did it, they think they should do it too," said Mr. Gaskins.

Perhaps they also want to do it in order to create permanent capital so that they have a future. Those large and successful partnerships have a need to transfer ownership to other generations or to talented employees and they can't do so without creating a stock that they can sell, said Mr. Hendrix.

The desire to make a quick buck with over-inflated valuations, which was invoked as the main driving force behind the Blackstone or Fortress deals, does not seem to be part of the picture at present. Could it be the end of the hedge fund IPO fever? More likely, managers will find other ways to access the institutional capital they need. And going private is an option that at least is consistent with the private equity culture.

Spokesmen at KKR and Apollo declined to comment. A spokesman at Och-Ziff did not return a call.