Steer Clear of the Private Equity IPO Train

Pat Dorsey: Hi. I'm Pat Dorsey, director of equity research at Morningstar. The private equity IPO train has begun to heat up. Over the past few years, it's always been a question as to when all of the mega deals that occurred in 2005 to 2007 back when credit was basically free, when all these private equity deals would come back to market. Because, of course, when private equity firms take a company private, they need to take it public again later or sell it in order to realize some cash returns, which they can then distribute back to their general partners and other investors.

With Kinder Morgan, this week we're having one come out. We've also seen Neilsen recently, Freescale which was a spinoff from Motorola, a semiconductor company that got LBOed for about 15 billion in 2007. That's just filed to come back out. We have Toys "R" Us, HCA, and Hilton Hotels in the pipeline as well.

What worries me about this trend is that we're seeing a private equity take a little bit of a victory lap. You're seeing some very kind of nice chatter about these nice returns they have reaped for their shareholders. But I think it's worth bearing in mind that some of the companies that have been coming out recently such as Kinder Morgan were some of the better ones to have gone private.

Kinder Morgan, one of the very large natural gas pipeline operator has always had very, very strong fundamentals and when you operate a pipeline, essentially a toll bridge, you can take on a lot of debt and support that debt with your cash flows. For a business that's much more variable, like a Toys"R"Us or a HCA, levering up is a much riskier strategy. Of course, we have not yet seen some of the more troubled and expensive deals of the buyout-bubble era like TXU, Clear Channel and Univision, we haven't seen those starting to file yet. So I think that any signs you hear of a victory lap by private equity should be taken with a large grain of salt.

More importantly, from an individual investor perspective, we are seeing a lot of interest in these IPOs judging by website traffic and by some of the emails that I get. People asking whether they should be interested in getting a piece of the Nielsen IPO or the Kinder Morgan IPO or these other deals when they come to market. The answer to that is almost unequivocally, no, because if you are a private equity firm that bought a company out, loaded it up with debt, perhaps made some operational improvements and then needed to sell it back into the public market in order to realize some cash returns for your investors: would you bring it to market and attempt to sell at a time when the shares were cheap or when you thought you could get the best price possible? Well, I would hazard to say that it would be at the time who would get the best price possible. If the seller is getting the best price possible, well, the buyer is not getting a very good deal.

As is usually the case, the Oracle Of Omaha, Warren Buffett put this most lyrically in a comment he made about IPOs some years ago that "it's a near mathematical impossibility to imagine that of the hundreds of thousands of things for sale in the market on a given day, the most attractively priced is the one being offered by a group of knowledgeable sellers [this would be private equity firms in this case] to less knowledgeable buyers." Because, of course, as public investors we only know what's in the S-1 filing, the IPO filing, but we don't know the business as quite nearly as intimately as the folks who have been running it for the past few years while it has been private.

So, I would say that as a minority investor, to view most of these IPOs coming to market with a great, great deal of skepticism. The other quote about IPOs I have always liked is why in the world would you buy an asset at a time and price of the sellers choosing? You don't get good deals that way. Just a note of caution, with all the IPOs coming to market, you are seeing a lot of froth around them. The media likes to talk about them a lot, usually in very exciting terms, but so far we have not seen any that are attractively priced from an investor perspective.

I'm Pat Dorsey. Thanks for watching.