PureVC

Public Equity Firms

I previously posted a few times about Blackstone, Fortress, and KKR going public. I've always felt that it is not a great idea for private equity firms to go public. You can read my other posts but in general the public does not understand how private equity firms work, are not suitable investors for private equity, and do not have the patience to invest in private equity. The markets have borne out these truths, hammering the stocks of Blackstone and Fortress in the US as well as KKR's listed vehicle in Amsterdam. Some of these firms are probably valued less than their NAV.

Perhaps the largest untoward effect of the revealing of private equity secrets has been the extreme jealousy and attack at firm founders and what is considered exorbitant or even egregious pay. As a result of the IPOs of these firms, the spotlight has been put on the industry and it for the most part is a negative one. The government continues to want to come after carried interest and continues to want to increase revenue and cutoff any tax loopholes in all of private equity, be it venture, hedge, or buyout categories.

You already know how I feel about the effects this may have on our competitiveness as a country - there must be incentives and rewards for innovation and risk taking. Take that away and people will go elsewhere, be that the London AIM or Amsterdam exchanges.

Given that many firms still want to follow suit into the public market and they want to improve their public image, firms are responding to public inquiries. Now that we are in a credit crisis, firms are even announcing to the public that their funds are not affected and that their assets are safe.

Back in the day as private firms, this would have never happened. Firms would attend to their matters privately. Investors would get their distributions when they came and all parties would be happy.

I continue to believe that private firms should stay private and do what they do best.

Blackstone & Fortress - Private Equity Goes Down in Public History

It's been a long week for me but I really must post on some of the historical events of this week. First, Blackstone's offer to LBO Equity Office Properties marks the largest buyout in history. The public courtship of this valuable office REIT definitely turned it into a match of pride. Some critics question the viability of the deal given that bidding originally started at $48.50 per share and ended at $55.50 per share. I believe that there is value in the deal even at this high of a price. However, it is obvious that as competition in the market for private equity increases, so does the value of winning these "Trophy Deals" to differentiate the best of the best. We'll surely see if the financial wizardry of Blackstone can handle the leverage and weather any downturns in the commercial real estate market. I suspect that as the dynasty of Blackstone enlarges, this will only be a benchmark deal in a string of larger and larger buyouts.

The second event is obviously the Fortress IPO. I wrote about the S-1 previously. Since that filing, several stories have been written about how the main principals have taken out over a billion dollars in fees from the company. Despite many pundits going off on how unequal the ownership structure is of the IPO, the street rumor mill as of today is that the deal is 25 times oversubscribed. As I mentioned before, the guys at Fortress have been running a gold mine and it appears that they are about to pot it all.

If anything, this is another mere story of rags to riches, not unlike the Google or YouTube founders who have become instant billionaires. In every one of these stories, you see a handful of entrepreneurial people who have been opportunistic and caught a huge wave at the right time. Who would have guessed that a new platform for advertising on the internet would be worth hundreds of billions of dollars even as the tech downturn continued? Who would have believed that a website hosting videos would be worth billions? Who would have believed that a hedge fund could be so successful to virtually grow from few assets to a $7 billion market cap in 8 years with $30 billion under management?

What this all confirms is something most of us have already known. Private equity whether it be hedge funds, buyouts, venture capital, or real estate, is like any other business. It is about providing excellent service/products (returns) and making money (fees). And like lots of businesses that cash out by acquisition or public offering, so too can the private equity company.

The irony of course is that the business of private equity is essentially that - transacting in a non-public manner. Yet, the act of going public or hiring a public relations firm really is the opposite. Back in the old days PE partnerships didn't give a hoot who thought what of them - they had the money and the financial savvy and literally were barbarians at the gates.

What people may be overlooking is that like any other business that has a liquidity event for the founders, most of the time the founders move on and management changes. Perhaps that is why so many public companies are poorly mismanaged - the new managers don't have the incentive or the same passion as the original founders. I would argue that in private equity, more than in any other industry, the value of the firm is in the partners - their personalities, skills, experience, and connections are what make the deals happen. The main hedge fund strategist IS essentially the hedge fund. If that guy goes, so goes the fund.

We will see if the is the final act for Fortress and if their founders disappear into their billions. Hopefully, they will have too much pride and passion for their trade to let everyone down.

Fortress Finalizes IPO Terms

Fortress Investment Group finalized its S-1 filing today with a proposed market capitalization of $7 billion. They are among the first global private equity firms that are listing themselves on the public markets. Other firms have listed single funds on the exchanges as ways to raise permanent sources of capital. Fortress is taking the next step and taking their entire firm public.

I am not going to go through the S-1 in detail - this one speaks for itself - a 9 year old firm with $30 billion under management founded by a handful of guys in their early 40s. Take a look at the revenue from management fees and incentive allocation and you will see a pot of gold.

An unintended consequence of this move to become public is the intense scrutiny the firm is opening themselves up to by being a public company. Their S-1 begs the question: Why go public? If this is such a profitable business for its managers already, what do they have to gain by going public?

The company is listing the following reasons: people, permanence, capital, currency. In essence the firm feels that being public will allow them to provide financial incentives for employees, have permanence as an institution, more easily access capital from the public markets, and have extra public currency for acquisitions.

These are all solid reasons and Fortress is definitely showing they want to be a pioneer of Private Equity and go down in history. It will be interesting to see if other firms follow.

My personal feeling is that private equity can be risky and the public may not be equipped to tolerate this risk. On the other hand, PE firms are becoming so sophisticated that it is difficult to differentiate themselves from the investment arms of most prominent boutique investment banks. If Goldman, Lazard, and other boutiques can go public, it shouldn't be any different for great private equity firms.

Ryan Beck acquired

Last week Ryan Beck announced that it pulled its IPO after it was acquired by Stifel Financial for about $120 mm in stock, including payouts. I previously posted some thoughts on the Ryan Beck S-1 filing. It seems that this is starting to become a common theme in the marketplace - companies looking for funding either privately or on the public markets and then being acquired in the process. I don't have a lot of details in the acquisition, but it seems like a bargain price for the company which in its S-1 filing recorded $250 mm revenue. From the BankAtlantic CEO as quoted in the South Florida Business Journal:

"It was the Stifel track record that convinced us that a primarily stock-based payment was preferable, providing BankAtlantic the opportunity to maximize the return on our investment in Ryan Beck," Levan said. "While we have no immediate plans to sell any of the Stifel stock that we will be receiving and there are limitations on our sale of the stock, we do anticipate gradually reducing our investment, consistent with market conditions and as the combined companies begin to realize the benefits of the consolidation."

Read - we think we will make more money selling Stifel stock because it has a stable trading history versus if we just sold our public IPO stock.

Why I Don't Buy IPOs II

I have received some grief for my previous post, Why I Don't Buy IPOs? Some readers were a bit shocked at how I could be a VC yet not buy IPOs. I wanted to follow up and clarify a few things. First, as I mentioned, IPOs can be a great investment if you have the chance to get in on a tranformational company. The problem is that access is still a huge problem. If you aren't a major financial player, you will have trouble getting in on an IPO of a very solid company. Notice that I am not referring to a "hot" IPO. A good IPO and a "hot" IPO are not always the same thing.

Secondly, there are several reasons why I don't buy IPOs. The two main ones are that I don't buy public stock that much because I don't have the time or the energy to research the dynamics of the public market. At the time of an IPO I do know a lot about the company, but a few quarters down the road, unless I am intimately involved in a company I will probably know its stock price but I don't scour quarterly earnings like I research S-1s.

The other main reason is that I have an abnormally large percentage of my personal assets in Private Equity. While that may seem counterintuitive or give me justification to buy public stock to balance things out, I prefer either holding Private Equity or cash. I have already mentioned that I do own some significant autopilot type of investments in public stocks, but the underlying holdings of those vehicles are not under my control.

One last reason is this - a VC or anybody who sells an interest or security to someone else has a fiduciary duty to be a responsible manager of their interest. When a company goes public that I invested in privately, I have to make a determination whether it is in the best interest of the LPs to realize their gain or not. As you have already read, more often than not, it is in their best interests to liquidate. One thing I did not mention is that liquidiation does not necessarily mean that the stock is sold. We are allowed to distribute stock and record the gain in our return books as of the day we distributed the stock to the LPs. So if our LPs decide in their own judgement to hold their stock rather than sell it, that is their call. We did the best we could and gave them the stock at a price that we determined was the best return possible on their private investment.

Suffice it to say that whether an IPO is bought or sold at the offering is more complicated for someone in the private equity industry than to the average person wondering whether it is a good stock or not. Every person has to deal with their own personal and financial circumstances. The VC additionally has to deal with the interests of his LPs.

Another VOIP Provider Files For IPO

As I suspected IPO filing activity continues to increase. Now I don't want my blog to focus too much on IPO filings so I am selective about the ones I write about, but this week another VOIP provider, InterMetro, has filed its S-1. When I previously said in my last post about the DivX IPO, that things were heating up and the quality of offerings seemed to be declining, I wasn't kidding. InterMetro's filing shows that they are a young post-bubble company that started offering VOIP services in March 2004. How can a money losing one year old company expect to tap the public markets and thrive? This is scary!

The VOIP space is indeed turning out to be "Web 2.0's" fertile ground for liquidity. I have posted about the evolution of this space previously. It started with the acquisition of Skype by Ebay. Then Gizmo's commercialization and VOIP wars between Skype and Gizmo and the introduction of Jajah's service. Then the Vonage filing. And now InterMetro.

I'm not going to waste much space on InterMetro because you all know that this is another company that is trying to strike while the iron is hot. VOIP is hot so you are going to see the floodgates open. I am however a little surprised because EVERYTHING IS GOING SO WELL with the second generation of web companies. There is NO NEED TO SPOIL IT BY CRAPPY IPOS! When you have momentum such as we clearly have since the meltdown, you can't get greedy and take your company public prematurely.

People often forget that even in a free for all marketplace such as the equity capital markets, you are interconnected with everyone else. While the markets are an efficient place that eventually punish and reward according to fundamental merit, they are influenced by emotion and psychology. If you take your company public prematurely you are doing the markets a disservice. People will lose money and not want to come back. You will get punished when you don't perform and then you will make it more difficult for others to go public. This prevents all of those innovative technologies from reaching the hands of the public.

Now maybe I'm being melodramatic. But the underwriters of this IPO, Ladenburg Thalmann & Co and Wunderlich Securities are two no name underwriters who I have never heard of before. Shame on you two no name banks that are trying to make a buck.

So I'm going to skip my rundown on this IPO - it is a one year old company in a highly competitve industry whose losses are increasing as rapidly as its revenues. The only thing I give these guys is that they have some real cajones for filing.

Why I Don't Buy IPOs

I've posted a string of posts reviewing S-1s. Interestingly, since my post about the Vonage IPO, traffic at my site has gone up almost 500%. I suspect that people are considering buying the IPO and are doing some research. Not that I care about readership numbers as I have removed all advertising from my site. At any rate, even though I have said I am not buying the Vonage IPO I want to add a disclaimer - this blog does not give recommendations on specific investments. While I clearly show my bias toward private equity investments, I do not recommend any specific manager or fund or investment.

I generally don't buy into IPOs or public equities that much. I used to buy IPOs and public stocks all the time, but I do not much anymore. When I do put on an occassional trade in my trading account, it is more out of boredom and in the interest of making a quick buck than for long term investing. I do have some significant autopilot type investments in mutual funds, but I really couldn't tell you their performance or whether they are 4 or 5 stars.

Why don't I buy IPOs? I am a VC. I make my money by creating value for companies. When a company goes public, the stock I have bought has already made a large multiple. I have taken the risk of illiquidity and turned it into liquidity and am duly rewarded. If I can unload at the IPO price I will make my investors a ton of money. If it goes higher I will make them even more. VCs are usually subject to 6 to 18 months of lock up of their stock, so it is my best interest to wait until a company really has momentum before letting it go public. There is no point for a VC to take a company public that will get hammered when it doesn't produce strong earning for 4 to 8 quarters after the IPO. Granted, usually a VC firm can sell some stock at the IPO offering, but usually the money comes  after the IPO.

So when I see a company going public, I know that some brilliant VC and the founders are getting liquid and cashing out. Any appreciation beyond the IPO price is GRAVY!!! But the meat is already being eaten at the IPO price.

Now this doesn't mean that money can't be made by buying IPOs or trading public equities. I in fact made my first chunk of dough by trading public equities for my own account. There are great companies out there that have made people a lot of money on the public markets. Fortunes will continue to be made on these markets. Just be aware that when you buy an IPO, you are buying something that someone has been holding onto for several years and is only now able to sell.

I'm not saying that there are not good IPOs to buy. Sometimes there is a unique company that is the major player in its space that will transform its industry. Problem is that if you are the average investor you won't get shares. But those kind of companies can always be bought on the open market after the IPO. If their chances of success are so great, then it won't matter whether you got shares at the offering price or on the open market. Trust me, there is always an opportunity to jump on the bandwagon of a great company.

DivX's IPO filing

Another yummy S-1 appeared late last week from DivX, a provider of software that allows compression-decompression of DVDs and movies. This S-1 interests me because DivX is a bubble-era company that initially gained prominence by its software that allowed the compression and decompression of illegal copies of movies floating around the internet. Previous to companies like DivX, movie files were too large to be transmitted over the internet. After DivX, all you needed was a fat broadband connection and your buddy could connect to you via firewire or transmission could even be possible over instant messaging networks. For those of you who have always wondered how companies who give away their product for free eventually make money, here in DivX is a good example. After gaining popularity, DivX has started supplying OEMs allowing consumers to buy machines with the software pre-loaded.

The DivX filing is significant to me because it is yet again another IPO filing from a tech-bubble era company funded in 2000 that survived the meltdown and has achieved profitability. Since the meltdown, there have been countless articles written about venture capital overhang. While the popular press has worried about unused capital commitments, I’ve never really felt this was a real problem. The problem since the meltdown has been a tight IPO market with few liquidity channels available. Consequently, when VCs can’t achieve liquidity, their portfolios become larger and they are hesitant to put new money to work. When this happens, uncalled capital commitments build up and management fees accumulate and thus overall returns are dragged down a bit.

When liquidity channels are tight, venture investors must hold onto their companies longer. VCs won’t invest as readily in this environment. People think this is primarily because VCs don’t want too big of portfolios at one time and that they want to be able to manage risk in their portfolio by seeing if early bets will pay off. While the latter is partially true, the real detriment to having tight liquidity markets is that industries do not mature and evolve well without exposure to the public markets. VCs need their companies to go public so they can get a return on their investment as well as to see those markets mature and evolve. Industries do not change as rapidly until several companies are public. Several things are allowed to happen when tapping the public markets – increased merger activity, new ventures, consolidations, and products related to economics of scale.

The DivX filing is a clear sign that things are heating up. There is a feeling in the venture community that now is a great time to take those companies public that they have been holding onto. If you take a look at next week’s anticipated offerings, you will see Interwest Partners actually has two companies slated to go public, QuatRx and Novacea. In their defense, those companies are both out of Interwest VIII, which is a huge fund, so it is probably a coincidence. While I am happy for all of my venture brethren to get liquidity and turn those ROIs around, I am also a bit worried. I know of several companies that are contemplating their S-1 filings. Some are ready for the public markets, some are not. If you notice the SEC filing activity, you will find that the quality of companies has declined a bit and 3 to 5 quarters of profitability is not required. In addition to the poorer quality of companies, I am also noticing that management and shareholder teams have lots of 30-year olds on board. Not that I have anything against young people, but this trend reminds me of years past.

So before I forget, let's be students of the S-1 on the DivX filing:

Principal Shareholders: R. Jordan Greenhall (CEO), Zone Venture Fund, WI Harper Group, Insight Holdings.

Company Story: Started in tech-bubble 2000 initially providing video compression software, now including a media player, selling to OEMs now.

Leadership: Management team of several 30 something year olds, including CEO R. Jordan Greenhall, a 34 year old who had a brief stint at MP3.com before starting DivX. He’s a Harvard law grad. Interestingly, two of their managers hold the “CXO” title, which I have never seen on an offering memorandum. However, I am obviously getting a kick out of it as I have adopted that term for my own VC firm. Another interesting thing about their filing is their note to investors which eerily reads a bit like the introduction to the Google filing.

Financials: Expanding revenues of 8 mm in 2003, 16 mm in 2004, 30 mm in 2005 with 2 mm of profitability last year.

Final Assessment: This is a company that has survived the tech meltdown and appears to have momentum. No valuation is listed in their offering, but they have about 33 mm shares outstanding so I would estimate a 250 mm to 350 mm valuation which is around 10x 2005 revenue. This is an intensely competitive sector but this is a young management team that has survived some difficult times. It will be interesting to see how well received the offering will be.

Vonage's IPO

As reported by the Red Herring, Vonage has amended its S-1 filing, signaling that its IPO may be around the corner. I've previously posted about Skype's acquisition by Ebay. It appears that the Skype valuation has influenced the implied valuation of Vonage. Yet another example how a private transaction can influence a public valuation, and more importantly, leave individual investors in Vonage hanging onto the bill.

I've already talked about VOIP wars between Skype and Gizmo as well as Gizmo's Area 775 and Jajah's upcoming new service. What is interesting is that Vonage is clearly the worst of the VOIP players, yet it has the largest user base and is the most well-funded. Even the Red Herring article quotes a research analyst quipping that perhaps Vonage should use more of its funds to improve its product offering before going public. This so much reminds me of AOL's initial online service offering pre-internet bubble. At the time, AOL's service was shoddy at best, yet they had a monopoly on the market and first-mover advantage. Clearly they would not have survived had they not diversified into a media conglomerate. Perhaps the fate of Vonage won't be so different.

Before I go let's quickly be students of the S-1 and rundown 4 key features in the amended Vonage filing:

Principal Shareholders: Jeffrey Citron (CEO), Bain Capital, Meritech Capital, New Enterprise Associates, 3i Global Technology. Interestingly, Gov. Tom Ridge (of Homeland Security) has shares and is a director (I'm not sure how the hell he got a Directorship and maybe he sucks at Homeland Security, but he knows how to profit from his position!)

Company Story: Started in post-bubble 2002, 95% customers U.S., apparently Citron started it with lots of money from Datek.

Leadership: Jeffrey Citron owns 41%, but is stepping down as CEO, apparently he did some shady stuff at Datek and had to pay some fines and is barred from the securities business. He is young, only 35! He makes about a million in salary and bonus, not including about 4 mm he has in options and not including the 41% of Vonage he owns. Obviously he is somewhat of a badass that has gotten into some trouble before, but he is obviously a mean businessman. And now he is gonna be one rich thirty-something!

Financials: Expanding revenues of 19 mm in 2003, 80 mm in 2004, 270 mm in 2005 and 120 mm through March 2006. Expanding losses from inception until now is  $455.1 million. 2005 loss of $261 mm and loss of 73 mm through March 2006.

Final Assessment: This is a lofty valuation that would concern me as an investor. Given that I have some holdings that have Vonage stock and stock of other VOIP players,  I am not too worried, but I am certainly not buying into the IPO. Such a valuation for such a big money loser will certainly bode well for existing VOIP players who may be looking for liquidity.

Ryan Beck Files for IPO

Yet another investment bank has filed for an IPO. We previously saw Thomas Weisel go public. It is always interesting to ponder why an I-bank wants to go public. These are after all, some of the most lucrative businesses in the capital markets. They perhaps, some would argue, are the engine behind the liquidity of our markets. If you recall, a primary reason Weisel went public was to payback its bankers and partners who were loyal in the early 2000s as much of the technology business declined.

Similarly, in the Ryan Beck prospectus, they cite that common reason:

"We expect that our transition to a public company will enhance our ability to execute our growth and diversification strategy. We believe that as a public company we will have better visibility and broader access to capital. We also expect that it will enhance our ability to attract and retain high quality professionals by enabling us to offer them equity-based incentives linked directly to the success of our business."

Read in plain English - "We think that having stock will better publicize our company. We also need stock to better pay our bankers."

I actually think that is an OK reason to go public. At least they are being honest. The investment banking industry is fiercely competitive with boutique firms always trying to undermine the monopoly of the bulge bracket banks.

Who knows how the IPO will fare, but they have interesting numbers from a so-called "Investment Bank". They derive revenue primarily from three sources: Private Client, Capital Markets, Investment Banking. Of their $250 mm in revenue, $150 mm comes from Private Client, $50 m from Capital Markets, and $50 m from Investment Banking. So it is no surprise that this firm isn't listed on a lot of prospectuses or isn't often listed in M&A rank tables.

So Ryan Beck appears to make most of their money on trading commissions. This is not surprising given that they were initially founded by two bond traders, John Ryan and Roy Beck, as a bond-trading house. Despite their interesting history, if I were an "Investment Bank", I wouldn't want most of my money coming in from commissions. That is a tough business and as technology improves, those spreads are going to thin even more.