Private equity: Best of both worlds

If managed well, exiting from an investment via a twin-track IPO or M&A can reap huge rewards, says Stephen Lloyd

For the many private equity sponsors seeking to exit from their investments via a ‘twin-track’ M&A or IPO process, it is vital to have a coherent strategy from the outset.

The past 18 months have seen private equity sponsors seeking to cash in on their profitable portfolio investments. To maximise the proceeds, some have sought to run both a sale and an IPO process simultaneously, deciding which option to select only at the very last minute. If managed well, such a twin-track process can create considerable competitive tension and produce an attractive outcome for the sponsor.

As well as delivering an optimum sale or IPO share price, the element of competition allows the sponsor to exert pressure on buyers and minimise adverse terms such as conditionality, material adverse change, warranties or indemnities. Managed badly, the processes can fall out of step, resulting in considerable extra cost and work without ultimately improving the sponsor’s outcome.

IPO or M&A?
It is critical for the sponsor’s advisers to take a firm view early on as to which is the most likely outcome. Is the target really a candidate for an IPO but with the share price validated by an M&A process? Or will it more likely be sold, so that the IPO is just a means to galvanise the buyer group? It is rare, though not unheard of, for both outcomes to be equally viable and attractive. But where that is not the case, choosing which route will lead the process is fundamental to achieving the best outcome.

Broadly, an IPO process tends to be more public, adviser-intensive and regimented than an M&A transaction, which remains essentially ‘private’ in nature. In brief, it is easier to accelerate an M&A process at will than an IPO. The obvious consequence of this is that if an IPO is to remain a viable result until the latest possible time, it may be necessary to slow the M&A process artificially or to start it some time after work has begun on the IPO.

This position is exacerbated where one of the buyers tries to forestall the auction process and buy the target early from under the other bidders’ noses. This can be attractive to the seller but creates a dilemma. Does it commit urgent resource to the ‘pre-emptive’ buyer? Failure to do so can mean the loss of a high price earlier and more cheaply than had the auction and IPO run their course.

But by committing to one path too soon the seller can lose leverage both with that buyer (which will know that it is now in a strong negotiating position) and with the rest of the buyer and IPO group. If the pre-emptive sale fails, it will be hard to salvage either the auction or the IPO. Pre-emptive bids are usually therefore only countenanced where the price is extremely high and there is near total elimination of execution risk, and in particular where the pre-emptive bid is not subject to substantive conditionality.

Process hurdles
There are parallels between the key process hurdles in each route, but also critical differences that impact on the ability to switch tracks at will.

At the outset of an auction, typically a set of vendor due diligence reports (VDD) will be produced by the seller advisory group for the benefit of the ultimate buyer. Similarly, in an IPO the target’s advisers will perform an extensive diligence exercise on its business. This is often referred to as the ’10-b-5′ process, after the US standard to which a prospectus must be prepared.

There is, however, a key difference in the two processes. A VDD is an elective process, where the sellers can choose precisely what work is done, on what areas of the business and to what level of materiality. By contrast, a 10-b-5 exercise must be performed to a level prescribed by statute. Anything material to a potential investor must be examined. It follows that, if a decision is made at a late stage to switch from a sale to an IPO, it may be necessary to re-open the M&A due diligence and re-examine the materials with that different standard in mind. This can derail the process.

The key information document in an auction process is the Information Memorandum (IM). Its equivalent in an IPO is the prospectus issued to shareholders (although the prospectus has legal status whereas an IM does not). As with the diligence documentation, the purposes of these documents and the standard to which they are prepared are very different.

The IM is essentially a selling document and generally focuses on the positive aspects of the business. It will contain, among other things, forecasts and projections for the future financial performance of the business. The prospectus, on the other hand, performs a statutory function and will not normally contain any prospective financial information.

An important issue for the sponsor therefore is to ensure that there is no possibility of disclosure of the contents of the IM into the IPO group. This can create liability concerns that could delay the IPO. The converse is not true and in fact it can be relatively easy in an IPO-led process to switch tracks at a late stage and use the detailed draft prospectus as the basis of a substitute IM for delivery to buyers.

Maintaining the balance
The incentivisation structure of the advisory banking group can be of great importance to the outcome of the process. It is common to see a single investment bank covering both M&A and IPO, but with other banks also tendering to underwrite the IPO price. The danger, of course, is that the bank that straddles both processes could suffer an in-built bias towards the M&A outcome where it will generate a sole, as opposed to a shared, fee. One possible solution to this is to divide the work streams between the banks in the normal way, but have all the banking group incentivised equally on both sides of the process. This may be easier to achieve in theory than in practice.

However carefully the sponsor’s strategy is formulated, the best laid plans do go awry and if there is a chance of the M&A process overheating before the IPO is ready to launch, some innovative structures can be used to bring more credibility to the IPO outcome – even if its launch is still some way off.

These may include the IPO banks agreeing in advance to underwrite at the appropriate time at a minimum or ‘back stop’ price, or that if they cannot obtain their projected IPO price they will themselves buy the target at the best auction price on their own balance sheet. Notwithstanding all of the above, the most effective strategy is to get the timing right, if necessary by staggering commencement of the two processes so that each reaches its ultimate conclusion at the same time.

Stephen Lloyd is a private equity partner at Ashurst