United States: Can a Dual Track IPO Secure an Exit For a Private Equity Investor?

Previously published in Financier Worldwide, August 2004

Like many techniques developed in the boom market conditions, dual track IPOs are making a comeback in a new guise in the slowly recovering but still turbulent equity markets.

Dual track means pursuing a stock market flotation (IPO) and a trade sale simultaneously, with an underlying intention of creating competition and price tension between stock market investors and trade buyers. The dual track technique was popular at the top of the markets up to the end of 2000, when new offerings were eagerly awaited and hugely oversubscribed. Many ‘new economy’ companies preparing for stock exchange listing were snapped up by competitors or other trade buyers who were prepared to pay a hefty premium for the acquisition.

The mechanism of dual track IPOs remains largely the same, but the objective is different: rather than enhancing the price, the aim is now to secure a sale.

A dual track IPO was developed to enhance the sale value by creating a competitive environment amongst investors and bidders. The approach is akin to a controlled auction, another private equity innovation for M&A transactions.

Running two parallel transactions can whet the buyers’ appetite for both. A possible interested trade buyer is likely to spice up the market interest for an IPO, in part because it can generate speculation about a possible take-over bid further down the line. Similarly, a keen strategic buyer may be prepared to pay a premium when it believes that the acquisition represents a window of opportunity – once missed, the target is going public and can be only acquired through a potentially costly take-over bid.

Dual track technique requires that the business is seriously attractive to both discerning and speculative buyers. It works best in an overheated stock market, but when the target is sufficiently attractive, it may boost the price even in a less excitable market. The dual track technique has been used successfully in some Australian transactions as late as 2002 and again in 2004.

Successful dual track transactions tend to have been led by a strong seller who can run two parallel transactions at the same time, sometimes with two separate teams of advisors. Often (but not always) the IPO team is not at all aware of the second track being pursued by the seller. The more secrecy is involved, the more experienced in-house team the seller needs to keep the exercise together.

In its new configuration, a dual track IPO involves much less drama and excitement. The seller usually gives a single mandate to one financial adviser to prepare simultaneously for a company’s IPO and a private sale or an auction. A single transaction team of investment bankers, lawyers and accountants is put in motion to prepare for the sale: if the stock market develops promisingly, the company will be floated on the stock market. If not, it will be sold to a trade or financial buyer.

Like so many M&A innovations, the new dual track technique has been developed to cater to the needs of private equity investors, who are keen to secure a profitable exit from their investment, one way or another.

Adual track may be appealing to a determined seller, but does it really make sense in the weak market conditions? How can one expect investors to get excited about a stock market debut by a company that is known to have been for sale before but has failed to attract buyers? Or why would trade buyers pay a premium for a business that has failed to float on the stock market?

For the seller, a private sale and an IPO fulfil the same function: realising the investment for the highest price obtainable. However, legally and economically a stock exchange flotation and sale of a private company are quite different animals.

An IPO is a regulated transaction scrutinised by the securities authorities and the stock exchange. It may enable existing shareholders to sell some or all of their shares, but the raison d’être of a flotation is to turn a private compa- ny into a public one and give it access to funding from the national or international capital markets. Preparations for an IPO should focus on the company: its management, business strategy – refining the ‘IPO story’ of the company and preparing the company for the demands of capital markets.

A private sale, in contrast, focuses on the owners – the present owner’s desire to exchange the company for the biggest possible pot of cash, and the future owner’s strategic vision on how it will develop the business. The buyer may be planning to split the target, refocus it, or integrate its business into the buyer’s existing operations, etc.

The contrast is most stark for the management and staff: a successful IPO is a public blessing by the investing market, a confirmation that the markets believe in what the company is doing. A private sale bears a negative message: the owners want out, they believe that somebody else can make more money with this business. When a private equity investor is selling, the element of no confidence may be absent (as everybody knows that a private equity investor is eventually planning to exit anyway) but the sale nevertheless induces instability and insecurity among the management.

A dual track approach can have a seriously demotivating impact on the company and its management, in particular when well-advanced IPO preparations are stopped because of the owners’ decision to sell privately.

A seller may believe that a dual track approach is a safety net in case one of the sale alternatives fails – you just move onto the other track, without losing much time or cost. The reality may not be quite that simple.

An IPO is a public sale and once launched, it can be withdrawn only in the full glare of publicity:

• If an IPO is withdrawn after launch because of adverse market conditions, it does not necessarily preclude another try later on. There are recent or pending examples of European IPOs that were pulled in summer 2002 that are now, some 24 months later, proceeding.

• When an IPO is withdrawn at pricing because of lack of market interest, the negative focus is on the company (and again, there have been several recent examples of this): the seller’s price expectation is now publicly known in the form of the initial price range published in the offering circular. If the market does not want to buy shares for that price, private purchasers are likely to press the price further down.

• If the IPO fails after the listing (i.e. the company’s share price flops at the stock exchange) that may not be much of a problem for the sellers who at that point would have already laughed all the way to the bank. The managers may try to recoup their losses through the representations and warranties in the Underwriting Agreement but that may be an uphill battle in absence of a clear liability on the seller’s part.

A private sale does not involve similar publicity. But no seller can assume that it can conduct a successful auction in secret. At least those parties who follow the company closest will know it is for sale: competitors, customers and suppliers are all possible bidder candidates and likely to be contacted in the process. Whilst all bidders are (or should be) bound by confidentiality agreements, there is usually too large a group of parties involved to keep the owner’s selling intent secret.

The common wisdom dictates that if you fail to sell a business in an auction you must be prepared to hang on and keep the business for at least 4-5 years before trying again. The cooling- off period may be shorter for a private equity seller, but even then a failed sale casts a long shadow over future attempts. There are some transactions currently pending where a company that has failed to sell privately is now being prepared for flotation – it will be interesting to see whether and how the past is going to affect the investor appetite and pricing.

So are there any practical guidelines for running a dual track IPO? When the shareholders have taken the somewhat fateful decision to run a dual track IPO / auction process, how can the management minimise the potential damage to the company?

One essential question is to decide how far the two parallel transactions can be taken without damaging the company or the prospects of a sale. For reasons discussed above, one natural break point is when either track becomes publicly or semi-publicly known. An IPO can normally be stopped any time before the launch. For an auction the breakpoint is much earlier, latest at the time when the financial advisor circulates the information memorandum to potential bidders. Unless the target is expected to arouse great investor interest, it may be prudent to cut the second track off before this point. There is much more at stake when the dual track is taken beyond the point when one track becomes widely known. A seller who is prepared to go this far needs a clear and objective view of the value and sale potential of the business. The seller also needs strong in-house team with substantial M&A expertise in order to keep the process under control.

From a cost point of view, there is some limited synergy between the two tracks. An underwriter’s IPO due diligence resembles a seller’s due diligence for a corporate auction. If properly planned and managed, most of the due diligence review can fulfil both purposes. Parts of an auction information memorandum can be recycled into an IPO offering circular. Avoiding cost duplication will require planning and managing as well as external advisors who have experience on both IPO work and M&A. And ultimately, the preparations are quite different and the further the two tracks are taken, the more costs duplicate. So an early cutoff point is advisable also from the cost point of view.

Each business is unique and must be measured against the general market situation – as mentioned, some highly attractive businesses have been successfully sold at the bottom of the market through an entirely public dual track transaction. Unfortunately, success stories are rarer than failures and eager sellers looking for an exit may be wise to exercise sober caution in assessing the possibility of engaging in a dual track IPO.

The information contained in this article is not intended as legal advice or as an opinion on specific facts. For more information about these issues, please contact the author(s) of this article or your existing firm contact. The invitation to contact the author is not to be construed as a solicitation for legal work in any jurisdiction in which the author is not admitted to practice. There will be no charge for the initial contact. Any attorney/client relationship must be confirmed in writing. You may also contact us through our Web site at www.kilpatrickstockton.com