Risk Latte - The problem of post IPO valuation

The problem of post IPO valuation

Rahul Bhattacharya
March 29, 2007

If a company goes for an IPO, then what should be the P/E be just after the listing?

This question may seem trivial and silly to some, who have MBAs, or who work in the investment banking area. Something straight out of Corporate Finance 101 course, one would say. In a recent job interview the interviewer asked this question to an interviewee on a business school campus. Of course, the interviewer asked this question out of sheer formality - he had to ask some question before he could hand out the job offer. And the candidate answered that question for five long minutes - he had obviously done enough number of cases and read up well on text books.

Honestly, most of us in Risk Latte cannot answer this question with any certainty or confidence. So we decided to pop this question to one of our friends who runs a successful asset management company. He said the answer was obvious. We said yes of course (as we normally do when we are not sure of an answer), take the cost of equity and invert it. That should give you the post listing P/E. To which he replied, "And where are you going to get that cost of equity from?" Our answer: simple, CAPM model. To which his simply said: do me a favour, don't say that again, please. Models scare me...... no one understands them and they don't work.

And he went on to explain: the simple answer, guys, is that investors have a very good mechanism of figuring out, without any models, that is, at what rate the company, which has just its shares, can grow its assets. And that would be the de facto growth rate of the earnings. If a company's asset base, working at full capacity, generates $1 of earnings then 5% growth in the assets should translate into 5% growth in that $1 earnings next year. And so you figure out what the projected P/E should be.

Why do companies go for an Initial Public Offering?

Most companies go for an IPO because they need money for growth and expansion. When a company needs money beyond what is provided by the promoters, venture capitalists or the private equity funds, it taps the public market for the first time. And mostly the money is spent on capital expenditures to grow the assets of the company. And a simple rationale for the price earnings multiple (P/E) of a newly listed company is that earnings should reflect the projected growth rate of the assets of the company, though in practice many a times that is not the case. It is the assets of the company that generate the income and eventually the cash flows of a company and hence the stock price of a newly listed company - in fact, any company - should be aligned to the growth rate of its assets.

But how about when a private equity fund itself goes for an IPO? What could be the reason(s) for a very successful and large private equity fund to go for public listing? And would we then value the company (fund) just after the IPO?

private equity fund itself is an investor in other start up and high growth private companies and more often than not the private equity fund makes a fortune when one of the companies that it has invested in goes public. That is the classical model. Invest in private companies, unlock the potential and the value hidden in the assets of the company, make those assets grow at double digit rate and then take the company public to cash out. This is the way how assets of a company can be made valuable. After all, all value is in the assets. In the classical model, private equity is a process which enhances the value of the assets of a firm. Of course, private equity funds these days invest in public companies, real estate and a host of other investment vehicles.

Recently, Blackstone Group, one of the most successful and large private equity funds in the world announced an IPO. This IPO has a couple of unique features, such as structuring the deal as a "limited partnership" and issuing units as opposed to a conventional limited liability company and then issuing shares. We are not going to go into those details here; but what is really interesting is that perhaps for the first time a private equity fund has decided to tap the public equity markets. And most commentators, including those from the left side of the establishments as well as some academics, are viewing this as a huge opportunity for the founder/promoters of the fund to cash in even bigger financial rewards than they have already done so far from their investments. Once the fund is listed the units (shares) will trade at a premium to their net asset value and for sure the controlling stakeholders will once again make and even bigger killing.

What multiple should the units (shares) of a newly listed private equity fund trade at? What kind of P/E should they command?

Once again the classical model provides the answer. A private equity fund holds stakes in multiple companies. Therefore, its exposure is to a large pool of assets. The growth in the assets of those companies should translate - ideally - into higher earnings of those companies. And all these individual earnings should be pooled in to figure out the projected earnings of the fund and its listed units' (shares') value can be found out from those earnings. Of course, in this case it is easier said than done. In fact, it can turn out to be - both theoretically as well as computationally - a fairly complex exercise.

One our colleagues suggested a different approach for this valuation problem. We will touch upon it in a subsequent article.

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