IPO process for Private Equity

By: Ana Cosniceru and Salma Abdellaoui

IPO is a term embedded in the finance lexicon that frequently appears when deliberating the business world in general. Conversations about private equity are no exception; the acronym will surely be alluded to as well. But what is it exactly?

This term refers to the “Initial Public Offering” or “Stock Market Launch” of a private company and represents the method through which the organization goes public and begins to list shares on a stock market. Usually, the shares are sold to institutional investors, but also to retail (individual) investors, who, through this procedure, receive a stake of the company and become shareholders. An IPO is an efficient way for private companies to raise capital from investors, to expand and to accelerate growth. In addition, the company benefits from increased transparency and credibility, which can heighten chances of obtaining better terms when seeking borrowed funds. Prior to the IPO, the company is considered private, being owned by a relatively small number of shareholders and funded by founders, family, and friends. After the company has reached a specific level of maturity, it may consider listing publicly. Typically, this inflection point occurs when it has reached a private valuation of approximately USD1bn – also known as “unicorn” status. However, this is not obligatory, and, of course, every company can decide when and if it is the correct time to go public.

IPOs generally involve one or more investment banks known as “underwriters“. The company offering its shares (the “issuer”), enters into a contract with a lead underwriter to sell its shares. IPO shares of a company are priced through underwriting due diligence. After the company goes public, the previously owned private share ownership converts into public ownership and the existing private shareholders’ shares are valued at market price. While some private shareholders may opt to retain their shares, or sell a portion or all of them for intermediate gains, the chrysalis of private to public is a key period to cash in and realize returns. This can also be a beneficial exit strategy. A business exit is an entrepreneur’s strategic plan to sell his or her ownership in a company to other investors. The former owner may decide that the business has met its profit objective, or that he/she no longer wants maintain a long position for personal reasons. IPOs are typically regarded as the best ways to exit as they often bring with them the greatest prestige and highest payoff.

In order to go public, a company must undertake various critical steps that can extend anywhere from six months to one year.

Step 1: Appoint an investment bank

This step consists of choosing an investment bank as an advisor to the company on its IPO and thus help it raise as much capital as possible. The investment bank is designated based on criteria which include: reputation, prior relationship with the company, industry expertise and distribution (ability to build and execute the order book). The bank under these capacities is called the underwriter.

An underwriting agreement, through which the bank sells the shares to investors on the company’s behalf, must be signed and includes details of the deal including the consideration of equity to be raised and the types of securities to be issued. While there may be some winking, at this stage, the investment banks will not make any guarantees to bear all the risks involved in the potential listing.

Step 2: File registration statements

The statement will include info about the company’s operations, finances, and management (fiscal data, the company’s business plan). It is divided into two parts:

  • The prospectus: a document containing the financial info of the company. This is then circulated by the investment bank and the company amongst institutions and individuals with funds to invest with the aim of stirring interest for the IPO
  • Private filings: enclosing info to the SEC which will not be made public

The financial authority will then investigate the disclosures to confirm that they are accurate and that the company is competent enough to trade publicly.

Step 3: Draft the Red Herring document

The Red Herring document is a draft memo that approximates the price per share to potential investors. The estimates are rough and by no means final. The purpose of the document is to read investor reactions and develop consensus on the pricing and enthusiasm surrounding the future listing.

Step 4: The road show

The road show is a marketing process to advertise the company’s shares to potential investors attempting to generate hype around the stock. A successful road show will allow a company to inflate its IPO price especially if the listing becomes oversubscribed. The campaign includes generous projections and facts and figures to encourage potential investment.

Step 5: Pricing

Once the IPO has been approved by the SEC and the road show is completed, the final price of the shares is agreed upon and locked into based on the offers received. The deal can either be oversubscribed or undersubscribed. In the former case, the price is set at the high end of the range and vice versa.

If an IPO is underpriced, the investors of the IPO expect a climb in the price of the shares on the offer day. This stimulates the demand for the issue. Furthermore, underpricing compensates investors for the risk that they sustain by investing in the IPO. An offer which is oversubscribed 2 to 3 times is considered to be a “good” IPO.

Step 6: Stabilization

This is a short phase in which the underwriter “creates a market” for the stock issued by providing analyst recommendations and aftermarket stabilization (i.e. exercising the greenshoe or reverse greenshoe option). It also must be noted that the underwriter is free to trade and influence the price of the shares (up to 15% of the initial offer price) during this allotment option window which lasts no longer than 30 days.

Step 7: Transition to market competition

This is the final stage of an IPO in which the investors redirect focus from the mandated disclosures and prospectus to market forces for information regarding their shares. This stage typically begins 25 days post-IPO.

After the IPO process, the company becomes listed on the stock market and is traded publicly. However, even after the ordeal of listing, potential hazards arise. Typically, companies face acute challenges in the post-IPO period.

Firstly, it should be noted that the newly-public company now engages with a larger scope of investors and is accountable for all of them. Therefore, it is integral to heed the market’s interest on the shares and manage public relations. In its public infancy, the company must build robust relationships with its shareholders, aligning them with the company’s core business and values, and deliver on its promises.

Moreover, a newly listed company is presented with new risks which it previously had no exposure to (e.g. limited corporate flexibility, risk of hostile takeover, etc.)  An adequate upgrade in the risk management processes may thus be required.

On top of this, the institution must balance its long-term objectives because, at the end of the day, the IPO is just one of the many milestones to be achieved.

PE

Finally, after developing an understanding of the process, the IPO can now be framed within the PE picture. The types of funds that will execute IPOs as an exit are typically those that garner portfolio companies in particular “IPO” industries. There is an observable trend in the sectors that usually opt for IPO exits and they include technology, healthcare and industrials. However, there also exist trends of IPO depression in the PE industry.

Recently, capital markets observed a significant decrease in IPO volumes. About two decades ago, approximately 300 IPOs were executed per year. Since then, the average has fallen by more than half; this means that publicly listed stocks in the U.S. have declined by 50% from 1996 to 2016. So what actually happened? What are the reasons for this considerable decrease and what are the drawbacks of an IPO?

Drawbacks

Firstly, consider that there are methods of listing companies publicly which do not qualify as IPOs. Ways of engineering this include creating SPACs or engaging in reverse takeovers. These innovative processes account for some of the IPO asphyxiation.

Aside from this, the immediate concern is the market. In a strong climate, IPOs can raise significant capital and several go overvalued (Uber), although nowadays there is an observable scrutiny of lofty valuations as mega IPOs like Peloton and Wework are being reevaluated. If the general sentiment for investment is lukewarm at best, then perhaps a trade sale is more appropriate as synergy-induced bids may offer more favorable valuations. Furthermore, many hot startups are being acquired by big tech companies which are growing and attempting to cater to as many customers as possible in as many ways as possible – thus creating a so-called “ecosystem”. There’s nothing wrong with ecosystems per se, but overall, the trend has reduced the number of IPOs and shifted the gains that overlooked high-growth companies might have produced in the public markets to private markets.

The IPO route does not always provide a clean exit for a portfolio company either as the previous owner retaining public shares in the entity is perceived as a good signal to public investors. If this is the case, the newly listed entity may also require the retention of directors from the GP. Add to this the fact that the IPO process takes significant time and may be distracting for the managers operating the business.

What was also common in past were the “dual-track” processes run by PE firms in which an IPO is explored in tandem with a majority sale. Due to the expenses related to twice the advisory services, portfolio companies which may have exited via IPO may only pursue private sales now.

Further to this, an IPO is severely expensive for companies, especially after introduction of the Sarbanes-Oxley Act in 2002. The stricter controls and accounting procedures are costlier. Therefore, the initiation of the launch can be relatively delayed because there is a need for higher earnings before going public.

Other regulations have also made IPOs less attractive. In particular: Reg FD (Fair Disclosure) and the Global Research Settlement (GRS). These require companies to disclose all material information to all constituents at the same time in order to avoid information asymmetry. In diminishing the value of analysts as conduits on the buy side, Reg FD may have impacted the value ascribed to sell-side research as well. Similarly, GRS may have altered the underlying economic viability of publishing research in banks although not the intention of the regulation. Banks now focus their research efforts only on large-cap, highly liquid stocks — at the expense of smaller cap ones.

 

Key Takeaways :

  • An initial public offering (IPO) refers to the process of offering shares of a private corporation to the public in a new stock issuance.
  • IPOs are a great opportunity for firms to obtain a large amount of capital
  • Companies are bound to meet requirements by exchanges and the SEC in order to initiate an initial public offering
  • Going public raises cash from the primary market issuance which substantially increases shareholders’ equity on the offering day
  • Public companies can have millions of shareholders
  • The process can be very long and not coincide to a company’s offering prospectus
  • Companies are required to work with at least one investment bank to underwrite an IPO.
  • Underwriters are involved in the entire pre-marketing IPO process
  • There is a chance that the underwriting fees can be a substantial portion of an IPO’s costs to the issuer
  • An IPO can be also seen as an exit strategy for the company’s founders and early investors, realizing the full profit from their private investment
  • IPOs as PE exits are becoming scarcer

 

Editor: Eric Peghini

Authors: Salma Abdellaoui, Ana Cosniceru