Every now and then a spectacular corporate failure comes along that causes a step-change in how investors apply their lenses to the market. For those who bought shares in the recently collapsed Australian electronics retailer Dick Smith, the step-change might be to insist that sponsors hold a larger residual position in a company after its initial public offering or to disregard private equity IPOs that look like a quick flip.
Dick Smith, which sells small electronics and home appliances through 390 stores in Australia and New Zealand, went into voluntary administration in early January just two years after listing on the Australian Securities Exchange and only five months after reporting a net profit of A$37.9 million on sales of A$1.3 billion.
The business was listed by private equity firm Anchorage, a specialist in distressed asset turnarounds, which bought Dick Smith from retail giant Woolworths in November 2012 for around A$95 million. The company’s valuation when it listed was A$520 million.
Matt Ryan, an analyst at fund manager Forager Funds, has called it the “greatest private equity heist of all time” and blames hapless investors for placing too much emphasis on Anchorage’s short-term forecasts, which in hindsight appear distinctly fishy. His analysis of the company at the time of the IPO showed a balance sheet brutally reshaped by asset write-downs, inventory sales, and the addition of 75 new stores. And he wonders why every other investor who reviewed the stock didn’t also see the red flags.
“This was a business that had struggled for a long time to make a meaningful profit, so common sense would tell you not to believe the hype,” Ryan said.
On reflection it was a risky move by Anchorage. The firm was only months into its turnaround of Dick Smith when favourable equity market conditions opened an IPO window. It found a set of numbers that could be dressed up for the prospectus and jumped through the window – a decision that may now have stymied its chances of using the share market to exit any investment for some time.
Too little, too soon
In the aftermath of the Dick Smith saga Ryan believes investors might be less willing to support private equity funds that head for the exits too soon after buying a business. “PE mandates usually don’t require an exit until the fifth or seventh year, so the only reason a fund would list a company after only owning it for nine months is because they think the timing is ideal.”
Sellers always know a lot more about a business than buyers and despite best efforts to improve the independence of prospectuses, they are inherently biased documents designed to sell stock. There’s no doubt that the good parts of Dick Smith’s business were overly emphasised in the IPO material.
Sam Sicilia, chief investment officer at A$17 billion retirement fund Hostplus, said companies walk a fine line between releasing information that tells only half the story and information that intentionally misleads investors.
“With the benefit of hindsight it’s easy to question the judgement of any manager that held Dick Smith stock,” Sicilia said, indicating that none of the 13 active equities managers mandated by Hostplus was invested in the company’s shares.
“However, in determining a manager’s rationale for holding Dick Smith stock, one should also ask whether there was publicly available information that was cause for concern.”
Investment bankers have been reluctant to criticise Anchorage’s conduct. One banking source FinanceAsia spoke to said the reason for the failure was less about Dick Smith’s balance sheet being denuded and more about the management’s inability to follow through with Anchorage’s vision for a leaner, more efficient business. Though it’s hard to see how anyone could have hit the company’s projected profit targets without enough inventory to sell and the capital necessary to invest in its expanded store network.
John McLean, head of capital markets origination at Citi in Sydney, expects a narrower IPO pipeline in 2016 due mainly to softer equity market conditions, not as a result of Dick Smith’s collapse.
“Investors will continue to support IPOs because they need new companies to invest in, though they may be a little more selective and may choose to pass on some offerings,” said McLean, who expects fewer IPOs from private equity vendors in the next 12 months as “funds move out of the recent divestment phase and into an investing phase”.
To be fair, investors in Australian IPOs have in general done well. According to figures compiled by UBS, IPOs initiated by private equity sponsors tend to outperform non-sponsored IPOs in the first 12 months of trade (see chart). Since 2013, sponsored IPOs have returned an average of 17.4% in the first year of trade versus 15.5% for non-PE floats, the data shows.
“The market will continue to assess each IPO on its merits,” said Dane FitzGibbon, co-head of capital markets at UBS in Sydney.
FitzGibbon expects one likely outcome from recent events will be an increase in vendors using the secondary market to maximise divestment returns. It is now common for vendors to hold at least some stock in a company rather than offloading 100% of the business – a practice popular in the Australian PE market prior to the global financial crisis.
The retained stock is held in escrow – a separate broker account opened on behalf of the sponsor – and released to investors through block trades after the announcement of results for the immediate forecast period. Hold lengths vary from between six to 15 months.
Market commentators haven’t always approved of retained stock, claiming it acts as a drag on share price performance as investors wait for the overhang to be released, but FitzGibbon refutes this notion.
“There are numerous recent cases that demonstrate the efficiency of block trades in clearing residual positions post IPO,” FitzGibbon said, pointing to four escrow releases in 2015 that priced on par with, or at a premium to, the companies’ prevailing share prices. “In November last year we underwrote the sale of a A$120 million block in Eclipx Group for vendor Ironbridge and achieved a 3.3% premium to last close.” The block at the time represented 15.8% of Eclipx’s outstanding shares.
Ryan at Forager is a proponent of gradual sell-downs and wants investors to push private equity vendors to hold on to more stock for longer. But he also warns against thinking that stock held in escrow is any indication of the future success of a business. After all, Anchorage conducted a block trade in September 2014 to sell the 20% of Dick Smith it had retained.
“You have to be careful you aren’t picking up pennies in front of a steamroller,” Ryan said.