"The idea that we're going to find a business to buy from a guy who's been thinking from the moment he bought only about how he's going to spruce it up and get out, is very low."
--Warren Buffett
As a value investor, when Warren Buffet speaks, I prick up my ears. At this year's Berkshire Hathaway (NYSE:BRK-A) (NYSE:BRK-B) annual meeting, he lambasted buyout firms, warning that the enormous amounts of capital they have attracted will make achieving above-par returns increasingly difficult.
Nevertheless, there have been some recent examples in which LBO funds have achieved outsized gains on portfolio companies after a very short holding period -- less than a year, in some cases. Early in 2005, buyout behemoth the The Blackstone Group took German chemicals company Celanese Corporation (NYSE:CE) public less than a year after it had taken it private. Between two special dividends and the value of its remaining stake in the company, Blackstone quadrupled its initial investment. Another top LBO firm, KKR, quadrupled its investment in PamAmSat, which it owned for under a year.
Car-rental company Hertz is set to complete its IPO this fall, after filing registration papers with the SEC in July. Hertz was acquired by a consortium of Clayton Dubilier & Rice, The Carlyle Group, and Merrill Lynch's (NYSE:MER) private-equity unit in December 2005.
In putting together these "quick flips," are LBO firms "appropriating profits that should belong to public shareholders," as outspoken hedge fund manager Dan Loeb reportedly said? My own inclination would be to answer "yes," but I'm always hesitant to draw conclusions based on a few glaring examples that might be unrepresentative. Thankfully, Josh Lerner, a professor at the Harvard Business School, and Jerry Cao of Boston College have crunched the numbers in order to shed some light on this topic (among many others).
In "The Performance of Reverse Leveraged Buyouts," they examine the three-year post-IPO performance of companies that had been acquired in LBOs, splitting them into two groups based on whether their IPO took place less than or more than a year after the LBO. Their results show that the "quick flips" underperformed the S&P 500 by 5%, while the companies that were kept private for a longer period outperformed the S&P 500 by 24%. While the results aren't statistically significant by traditional academic norms, I wouldn't dismiss them out of hand -- the probability that the returns of both sets of companies are different is approximately 4 out of 5.
As a value investor, I look at each company on its own merits. Nevertheless, I find that it's rarely interesting to buy IPOs in the secondary market. The attention surrounding the company and the favorable timing of the offering contribute to buoyant valuations that reduce future expected returns (there are exceptions to this, of course, like MasterCard (NYSE:MA)). This study provides some evidence that investors should be particularly careful if they are considering buying "quick-flip" IPOs. In these situations, the bulk of the returns may already have been made by the sellers, leaving shareholders with a meager chance of achieving acceptable gains. Caveat Emptor!
Related Foolishness:- The Return of Leveraged Buyouts
- Celanese Leaves Investors Scraps
- PanAmSat Goes Over the Horizon
- Hertz So Good
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Fool contributor Alex Dumortier has a beneficial interest in MasterCard. He welcomes your (constructive) feedback. The Motley Fool has a strict disclosure policy.
