IPOs of reverse LBOs not so bad after all, study finds

BOSTON — Initial public offerings of leveraged buyout-backed businesses have gotten a bad rap, two professors say.

Contrary to popular belief, the initial public offerings of leveraged buyouts, called "reverse LBOs" outperform other IPOs and the market as a whole, according to a paper released Sept. 29 by Josh Lerner, the Jacob H. Schiff professor of investment banking at Harvard University's Graduate School of Business, Cambridge, Mass., and Jerry Cao, a doctoral candidate at Boston University.

When these stocks drop, however, investors suffer because the buyout funds retain some ownership of portfolio companies after they go public. Also, investors are sometimes paid their share of the profit in company stock, and they also sometimes buy back the stock from buyout firms as part of the public equity investment strategy, Mr. Lerner said.

"To date, much of the discussion of these offerings has focused on a few troubled offerings such as Refco," Mr. Lerner said.

Private equity firm Thomas H. Lee Partners LP, New York, bought Refco Inc., a New York financial services company, for $500 million in 2004 and took it public at more than double the price in August 2005. Refco became insolvent just two months after the private equity firm that owned it took it public, filing for Chapter 11 bankruptcy on Oct. 17, 2005.

While there have been a few horror stories, Mr. Lerner said they studied 496 reverse LBOs between 1980 and 2005 and saw no evidence that the returns deteriorated over time, despite the growth of the buyout market. While Messrs. Lerner and Cao looked at data through 2005, the bulk of the IPOs occurred between 1980 and 2002 because they wanted at to track the stock for at least three years before making a claim about its performance, Mr. Lerner said in an interview.

On average, buyout groups typically own 55% of their portfolio companies before the IPO. Their average stake decreases to 38% after the IPO, largely because their ownership stake is diluted by new shares issued.

Reverse LBO firms do carry more debt than other IPO companies, the study found. Reverse LBO companies that go public carry an average 30% of debt, more than nine percentage points above the industry median, the paper said.

However, the leverage does not bring returns down.

"The popular press suggested (reverse LBOs) were over-levered and that these companies that were over-levered at the time they go public sink of their own weight," Mr. Lerner said. "Our study found that there is no negative affect."

Reverse LBOs sharply outperformed the market in the first, fourth and fifth years after going public, but returns were lower in other years. The market-adjusted mean return was 8.10% for the first year, 7.88% for the four-year returns and 15.45% for the five years. The two and three year returns were lower; the market-adjusted mean return was 3.47% for the two years and 6.34% for the three years All returns of more than one year are annualized.

IPOs of firms that do not have buyout firm investors only outperformed the market in a few years, including 1998 and 1999, the Internet bubble period, the study found. For every dollar earned from an S&P 500 index investment, investors following a buy-and-hold stock strategy would get $1.26 if they instead invested in reverse LBOs, the paper indicated.

The reason for the increased return is that buyout-backed firms are more prepared to make the transition to a public company, Mr. Lerner said. Buyout firms require their portfolio companies to be accountable in terms of corporate governance and management practices; other private companies generally do not have the same types of practices in place when they go public, he explained.

And the size of the deal matters. Reverse LBOs sponsored by larger buyout firms performed better, Mr. Lerner said.

Quick flips — companies taken public shortly after they were purchased by buyout firms — earned higher returns for investors than portfolio companies kept private longer, the study revealed. Companies that stayed private longer than the median 37-month holding period performed slightly worse than companies kept private for a shorter period.