Private equity and IPOs are staging a huge comeback.
But should advisors jump in?

The once-moribund market for initial public offerings is heating up as investors look for another crack at getting in on ground floor investment opportunities. Last year, 198 issuers raised $43 billion in the IPO market, according to Renaissance Capital in Greenwich, Conn. While that is far short of the $97 billion record set in 2000, it represents a vast improvement over 2003's deal volume of $15 billion and a healthy increase over last year's $34 billion total.
Much of the resurgence is being fueled by private equity, which also got walloped by the technology bust. Last year over 40 private equity-led IPOs debuted, accounting for four of the ten largest initial public offerings. Emboldened by low interest rates and companies with strong cash flow that can absorb the leverage their buyers saddle them with, private equity firms shelled out $660 billion globally for corporate buyouts in 2006, many of them multibillion dollar deals. With the war chests of firms such as Blackstone Group and Kohlberg Kravis Roberts & Co. stuffed with hundreds of billions earmarked for investment, the red-hot market shows no signs of slowing down.
The newest version of the Masters of the Universe bears little resemblance to the venture capital firms that poured billions of dollars into young, untested companies in the late 1990s, hoping to reap rewards in the IPO market. Instead, they typically borrow money to buy well-known, established companies, both public and private, overhaul their businesses and cash out through corporate acquisitions or mergers, sale to another investor group or an initial public offering.

Many investors are drawn by the potential to earn outsized returns and to diversify into an asset class with low correlation to other markets. Private equity also gives investors, mostly institutions, the opportunity to capitalize on the financial expertise of firms that have a proven track record of buying a company, taking an active role in its management and selling it at a significant profit.
But a rise in interest rates could slow the frenetic shopping spree for companies and cut into returns, and there is evidence that some private buyers are burdening targets with mountains of debt and selling them too quickly. The transactions could encounter roadblocks as institutional investors become increasingly concerned about surrendering publicly traded shares to private buyers at prices they consider too low, and regulators scrutinize debt-driven deal tactics.
Still, the publicity surrounding a number of high-profile deals has sparked renewed interested in an all-but-forgotten corner of the investment market. "Financial advisors are curious about private equity opportunities because they're hearing about high returns associated with them," says David Darst, chief investment strategist for Morgan Stanley's Global Wealth Management Group. "The question is how to tap into those opportunities."
Even for those willing to take the risks inherent in private equity investing, investment opportunities for most advisors and their clients remain slim. Private-equity funds of funds, which pool money to invest in private equity firms, have investment minimums of $250,000 or more and require investors to lock up their money for at least five years. There is no guarantee that an acquisition or other event that leads to big returns will ever happen. Fees are steep, with the general partner getting a large cut of the upside. Disclosure and transparency vary from firm to firm, with some providing little more than a few lines on their Web sites to investors. Feast or famine swings in returns produce a standard deviation that is significantly higher than the overall stock market, and performance can vary widely among managers.
"A private equity pool might be appropriate for an ultrahigh-net-worth client with $15 or $20 million in investment assets and a long-term time horizon, and even then I would recommend an allocation of no more than around 4% of assets," says Darst. "I wouldn't suggest these investments at all for someone who has a $1 million portfolio."
PowerShares Listed Private Equity Portfolio, an exchange-traded fund launched in October 2006, aims to fill the gap for smaller portfolios by owning publicly listed companies that "have a majority of assets invested in privately held companies or have the stated intention to have a majority of assets invested in private companies," according to a press release. Fund holdings, which include well-known private equity firms such as KKR Financial and Apollo Investment Corp., are disclosed every day, giving investors a much higher level of transparency than is often available in traditional private equity funds. However, as a recent article in Financial Advisor magazine pointed out (see "Do These ETFs Make Sense?" December 2006), the ETF is based on a narrow index containing a number of volatile small-cap names, and commission costs for smaller purchases could eat into profits.
The recent rebirth of an old product with a notorious reputation also aims to help investors cash in on the private equity boom. Special purpose acquisition companies, or SPACs, are formed by a group of sophisticated investors who become the management team once they make an acquisition. These publicly traded shell companies exist only on paper until they get money from investors at an initial public offering. Their goal is to buy undervalued private companies in a specified industry, often from a private equity firm, manage them to raise their value, and sell them for much more than they paid.
Critics contend these companies are little more than a new version of the blank-check companies whose popularity peaked in the 1980s, then declined after the Securities and Exchange Commission stepped in to investigate fraudulent activities. Even with regulatory reforms in place, investors face significant risks including limited liquidity, high fees and the chance that managers will never make an acquisition, or make one that they can't sell profitably.
Given investment options they consider unappealing, some financial advisors have decided to take more traditional paths into the private equity market. Ron Rogé of Rogé & Co. in Bohemia, N.Y., invests in stocks such as Capital Southwest Corp., a business development company founded in 1961 that provides capital and management assistance to small and medium-sized businesses in exchange for a major interest. Another holding, Investors AB, is an industrial holding company that invests in various sectors, including technology, engineering, health care and financial services. "I like the fact that I can see what the investment is worth every day," he says.

Crackle Without The Pop
The IPOs that provide an exit strategy for many private equity deals are seeing a steady though less spectacular comeback. While IPOs purchased at the offering price saw average returns of 24% last year, they only earned 11% in the aftermarket-far short of the 16.3% earned by the Dow and 13.6% by the Standard & Poor's 500. High-profile names such as MasterCard and Chipotle Mexican Grill posted spectacular triple-digit returns, while others, including Vonage Holdings and Digital Music Group, suffered double-digit losses. Venture capitalists are divided about what 2007 will bring, with 47% predicting a sluggish IPO market and half expecting to see a continued recovery, according to a survey by the National Venture Capital Association.
"We should see a better year in 2007 than 2006," predicts Linda Killian, manager of Renaissance Capital's IPO Plus Aftermarket Fund, the only mutual fund that specializes in buying initial public offerings when they hit the market or soon after they begin trading. Killian, whose fund has shrunk from over $200 million in assets in 2000 to around $25 million today, says emerging international markets and continued issuance by private equity-led firms should keep the market buoyant. While the pattern of recovery is "still in the early stages," she cites increased traffic at the firm's Web site and strengthening demand for the firm's research as evidence of a pickup in investor interest.
Another investment, First Trust IPOX-100, seeks to tap into initial public offering returns in an exchange-traded fund format. The IPOX-100 is a sub-index of the broader IPOX composite, which includes all U.S. IPOs. The composite incorporates the 100 largest and best-performing IPOs on the seventh trading day after they go public, and holds them through the 1,000th day of trading, a period of about four years. About 40% of its assets are in the top ten names, with Google accounting for about 9.5% of the index and a good chunk of the ETF's returns.
Because the index does not include stocks until they have traded for several days, the ETF does not get the initial out-of-the-starting-gate "pop" that well-connected institutional investors who get in at the offering price enjoy. Yet the characteristics of newly public companies that are less than four years old set them apart from typical growth fare, claims Josef Schuster, founder and CEO of index creator IPOX-Schuster. "It's a stretch to call them a separate asset class, but the dynamics of growth, expansion and change are very different from your typical publicly traded company," he says.
Killian estimates that she purchases about 20% to 25% of portfolio holdings at the offering price, which she says is "typical for an institutional investor." As the fund's returns of 115% in 1999 and -52% in 2001 illustrate, an investment that misses some of the starting gate pop can still crackle when the initial public offering market is hot and crack when it cools down.