EisnerAmper Private Equity Direct January 2010

To our readers,
This is the first issue of Eisner’s newest electronic newsletter, Private Equity Direct. Our goal is to deliver in-depth coverage of timely topics from industry insiders. This issue features articles on what is (hopefully) the cyclical return of the IPO market as well as the SEC’s proposed ban on third party placement agent services. In future issues, we’ll be examining the ILPA’s Private Equity Principles as well as releasing outlooks for 2010. We hope you find this publication to be worth your time. Feel free to contact me and let me know how you enjoyed it; I’d be happy to hear from you.
Peter Cogan
Co-Chair, Eisner Financial Services Practice Group 212.891.4047

IPO MARKET BEGINNING TO THAW Private Equity firms are cheering a possible return of one exit strategy, the IPO.

After a dry spell of well over a year, the market for initial public offerings is slowly ramping up.

That’s welcome news for private-equity firms. While the IPO window may be just inching open, the prospects look enticing enough that a number of companies are taking the opportunity to move into the public markets, including a few firms held in private equity portfolios. Over the past several months,, Dollar General, Rosetta Stone, and Avago Technologies, among other PE-backed ventures, have completed initial public offerings.

Year to date, through early November, 81 companies filed to go public with the Securities and Exchange Commission, according to information from Renaissance Capital, a Greenwich, Conn.-based IPO research firm. The number of filings jumped from four in the first quarter, to 11 in the second and 39 in the third. In October alone, 21 companies filed.

To be sure, even with this increase, the current rate at which companies are going public doesn’t compare to the headier pace of IPOs prior to 2008. In 2006, for instance, 293 companies filed to go public. That number jumped to 373 in 2007, before dropping to 151 in 2008, according to Renaissance.

“The IPO market is intensely cyclical,” says Josh Lerner, professor of investment banking at Harvard Business School, and private equity-backed offerings aren’t immune to larger market forces. If the IPO market remains open, it’s likely that more private equity firms will take advantage of public offerings as an exit strategy for some of their portfolio companies, he adds. For instance, according to news reports from October, Blackstone Group was planning to list as many as eight of its portfolio companies.

Does this represent a shift in strategy for private equity firms? After all, most private equity investors prefer to sell their portfolio holdings to a strategic buyer, rather than take their chances on a public offering. “The concern with IPOs has always been that you’re really at the mercy of the overall market,” says Michael Laveman, partner with accounting firm Eisner LLP. “Privately negotiating with a strategic buyer offers sellers a greater level of control.”

In fact, private equity investors have targeted IPOs as exit strategies for only about 13 percent of their investments, according to an analysis of some 21,000 private equity transactions between 1970 and 2007 by the World Economic Forum, “The Globalization Impact of Private Equity Report 2008.” Selling to another company was the most common exit mechanism, accounting for 39 percent of exits.

At the moment however, finding buyers has become more difficult, says Jeremy Kloubec, senior client partner for private equity at Infosys Technologies Ltd., a business solutions provider. Private equity mergers and acquisitions in the U.S. this year totaled $13.6 billion through July, or less than one-fourth the amount for the same period last year, according to Thomson Reuters.

The drop-off in deals is due to a mismatch between sellers’ and buyers’ expectations, Kloubec says. In addition, potential buyers aren’t able to use as much debt to carry out acquisitions, which means their purchases are going to be smaller.

The current jump in PE-backed IPOs also reflects the skill of private equity fund managers in timing the market, says Steven D. Dolvin, Ph.D., and associate professor of finance at Butler University in Indianapolis. “They’re very good at coming to market at the best time for a particular sector.”

A case in point is Dollar General. On August 20, the operator of 8,600 discount stores filed form S-1 with the Securities and Exchange Commission to go public. Dollar General is owned by Buck Holdings, a limited partnership owned by Kohlberg Kravis Roberts & Co., L.P. The proposed offering totals $750 million. “In the case of Dollar General, you can’t be better primed for a down economy,” Kloubec says.

Even as private equity investors decide it’s a good time to wade into public waters, they can’t guarantee that investors will be receptive. Some are going to be concerned that at least a few of the firms are coming to market simply because the fund managers want to get their money out while they can. If that’s the case, they may be bringing companies public that should remain private a while longer. “When the window is closed, you build up a backlog, and have to release it at some point,” Kloubec says.

Others express more confidence that the firms coming to market will succeed. For starters, IPOs really aren’t the most effective way for fund managers to cash out, says Scott Perricelli, partner with private equity group LLR Partners in Philadelphia. Even once an initial public offering is completed, the owners can’t sell a significant portion of their holdings until the lockup period expires. Instead, an IPO really is a way of valuing a business and providing it with capital for growth.

Moreover, private equity firms want to avoid a repeat of the kind of experience that Rosetta Stone, Inc., is having. The language software company went public in April, and got off to a great start, with its shares rising from about $18 to $25 on the first day of trading. For a time, it traded at over $30.

Things aren’t quite as rosy now, however. In August, after the company cut its third quarter forecast, the stock fell to about $21 and management pulled a planned secondary offering. As of early November, Rosetta’s stock was trading at about $18. Actual third quarter sales were $67 million, up 12 percent from the third quarter in 2008. Net income for the quarter was $5.3 million, exceeding the high end of the company’s guidance.

Fund managers definitely want to avoid bringing a company public, only to have it miss its earnings target the following quarter, Perricelli says. The stock price will take a hit, and may be left with little to no analyst coverage, he adds. However, the returns on PE-backed IPOs tend to beat, albeit slightly, the returns on other types of initial public offerings. That was the finding of a 2008 study by Lerner of Harvard and Jerry Cao of Singapore Management University. The two analyzed 500-some reverse LBOs, or initial public offerings of firms that had previously been bought by private
equity investors, along with 5,700 other IPOs over the period 1981 through 2003. The private equity-backed IPOs slightly outperformed the return on the S&P 500, while the remaining IPOs slightly underperformed.

“A lot of companies go public that aren’t really ready for prime-time,” says Lerner in explaining the difference. “They don’t have the systems in place to be effective in dealing with all the stresses associated with being a public company.” On the other hand, most companies held by private equity investors have had to face investors and answer pointed questions about their performance. Most also have a governance structure in place and experience preparing quarterly financial statements. SolarWinds, a provider of network management software, is one example. The company, based in Austin, Texas and founded in 1999, was backed by several venture capital and private equity firms. Its board of directors includes several veterans of other public companies. SolarWinds went public in May at $12.50, above the target range of $9.50 to $11.50. Revenue and profits for the quarter ending June 30 both topped 2008 results, and its stock has steadily risen to about $18.

While predicting the IPO market is iffy, the current interest in public offerings by private equity-backed companies probably is more of a short-term blip than an enduring change in strategy, Lerner says. For one thing, the universe of companies ready for an IPO at any point in time is relatively small. That includes companies in private equity portfolios.

In addition, the tight credit environment is making negotiated sales more difficult to complete, and is prompting private equity managers to look for another exit, Dolvin says. “This may be the single offsetting factor driving firms to IPOs in a market that is otherwise at the bottom end of the cycle.”


An SEC proposal to clamp down on "pay to play" schemes could make it harder for small and medium private equity funds to raise capital.

A series of ethical slip-ups within some of the country’s more prominent pension funds could have powerful transformative effects on the private equity industry, should the Securities and Exchange Commission get its way. A proposal published in August by the regulator suggests a sequence of reforms to the ways in which pension funds and third-party deal brokers interact — and has become a hot topic for private equity players in opposition to the proposed rules.

The SEC’s proposal, if adopted, would forbid private equity funds from using third-party placement agent services to solicit investment dollars from state and municipal pension plans, thus bringing to a halt the widely practiced use of such agents. The proposal would also block political contributions from parties seeking investments from those government entities, a shadowy, but not altogether uncommon, practice among private equity firms. “There are just a few small players in the country that have the political connections to do this,” says Charles Eaton of placement house C.P. Eaton Partners. “If the SEC bans political contributions, we would be happy to see these two-bit finders go away.”

The use of placement agents has become commonplace in private equity, with 54 percent of PE firms using their services in 2008, up from just 40 percent two years previously. The agents, who deduct their fees from the firms themselves, are responsible for a large portion of the investment that has flowed through private equity in recent years — illiquid “alternative assets,” which include PE deals, composed about 18 percent of U.S. pension fund assets at the end of last year.

The SEC’s major objective in its controversial proposal is to staunch the prevalence of “pay to play” tactics that have marred the PE landscape in recent years, with the ban on placement agents a largely secondary, but no less crucial, aspect of the proposal. “Pay to play” refers to the use of political donations (or, as in some notable cases, even more blatant financial offerings) on the part of third-party solicitors to curry the favor and investment dollars of state and municipal pension funds, which, nationally, hold $2.2 trillion in assets.

The SEC reasons that by stopping third-party placement agents, as well as explicitly forbidding political contributions within the investment advisory sector, there will be less of an opportunity for the kind of shady politically linked financial deals that have as late been an embarrassment for the private equity industry. As the SEC announced in its proposal, “Investment advisers whothat seek to influence the award of advisory contracts by public entities, by making or soliciting political contributions to those officials who are in a position to influence the awards, compromise their fiduciary obligations.”

The most infamous breach of such obligations between funds and the solicitors that seek to win their business is that which was uncovered earlier this year in relation to the New York state pension fund. A pair of aides to former New York Comptroller Alan Hevesi are alleged to have funneled millions — including $30 million straight to the pocket of Hevesi consultant Hank Morris — in fees from companies that won pension investment from the state fund. “Morris was essentially masquerading as a placement agent,” says Paul Denning of private equity firm Denning & Co., who notes that Morris’s standards of professional conduct were much lower than industry standard. “Our hit rate is like 7 or 8 percent, whereas Morris’ guys were at 100 percent. There were no standards.”

The SEC’s reasoning in its efforts to stomp out pay to play is multifaceted, and largely supported by the private equity community. The effects of pay to play are harmful to pension funds and independent brokers alike — and are more a matter than mere reputation. Qualified advisors and the advisory community at large are hurt when certain parties can simply buy the business of those funds whose investment dollars they seek, leading funds to invest in companies that may not be an ideal match. The pension plans themselves will pay higher fees to compensate for the corrupt advisor’s expenditures — and the advisor has a greater ability to squeeze other monetary rewards out of the pension fund. And, of course, the actual beneficiaries of the pension fund — state and municipal workers — aren’t happy to know that their retirement dollars were pushed into inappropriate investments, especially if these investments underperform.

“The ultimate goal of the SEC’s proposal is to protect public funds from abuse,” says Richard Marshall, counsel at Ropes & Gray. “But the question is whether the approach that they’re taking with this proposal will help public plans or hurt them.” Indeed, the critics of the SEC proposal have come out in droves during the document’s 60-day comment period, with many claiming that such changes will damage an already-fragile private equity climate. “Private equity is already laying lifeless as it is,” says Denning. “If the proposal goes through, it’s going to make it even tougher for PE funds to raise money from governmental entities. It’s also going to hurt those newer funds that don’t have the access to capital that the big guys have.”

Many critics have pointed out that the banning of placement agents is going to have a disparate effect across the PE field, with smaller firms bearing the brunt of the damage. Because the proposal allows a loophole — placement agents are allowed if they have an exclusive relationship with the capital-raising firm — it will be those smaller firms, who cannot afford in-house fundraisers and must outsource, that will suffer. “The rule has an asymmetry,” says Marshall. “And the question is, does this give an unfair advantage to the largest entities?” There is also the fact that placement
agents do indeed offer a valuable service to smaller private equity or venture capital groups that don’t have the necessary professional contacts to get an audience with large pension funds, all of which are constantly besieged by deal proposals. “The important thing from the funds’ point of view,” says Eaton, who has spurred a Washington lobbyist group to attempt to stymie the bill, “is that they will no longer see many small- and medium-sized fund managers that placement agents do a lot of work for.”

But the regulatory proposal, however unpopular, isn’t without precedent. A similar pitch, made under Arthur Levitt’s SEC in 1999, would have placed a two-year ban from accepting pension fund fees on investment firms that used third-party placement agents. The 1999 proposal died, but, ten years later, numerous pay to play scandals have forced regulators to consider the harsher measures of its latest proposal. Though the well known and egregious abuses allegedly committed in New York were the most highly publicized, they were by no means singular, with similar cases having been brought to trial in New Mexico, Connecticut, Illinois, Ohio, Florida, Alabama, North Carolina, and other states. The sheer volume of wrongdoing mandates some degree of policy change, says Marshall. “There have been a number of speeches that have been given that have identified this issue as a priority for the SEC. Clearly, the SEC will adopt something.” What remains to be seen — and what depends highly on the influence exerted by private equity groups and their attendant lobbyists — is just what kind of balance can be struck between fair play and a balanced, self-correcting market. The risk of overreaction, says Eaton, could wreak havoc within the industry: “We’re praising the SEC for coming to grips with pay to play, but we’re saying that if you go so far to ban the entire industry, you’re going to have a lot of unintended consequences.”

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