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April 25, 2012
Our Successful IPOs Add Volatility to Our Portfolio
When Kensington makes a new private equity investment, our plan is to grow the business to the point where it can be re-sold at a significant profit within 3 to 5 years. Typically, we target growth in the range of doubling or tripling the value. When it’s time to sell, we obviously look for the best price available, and it usually comes from a strategic corporate buyer through an M&A process.
Sometimes our portfolio companies have an opportunity to exit through the public markets with an IPO. A successful IPO requires a strong company with a great story for continued growth. And it requires the good luck and good timing to find a receptive public market. When all of these stars align, the IPO is usually the best choice because the public markets will nearly always pay the highest price. To put it another way, private buyers will pay a good wholesale price when they buy companies while the public markets pay full retail.
But IPOs are not easy. Normally, we cannot sell any of our shares at the time of the IPO, and can only begin to liquidate our position after a 6-month underwriter lock-up. Once we begin to sell, we can’t just dump our shares onto the market since, along with all of the other insiders, we would cause the stock to fall. So we gradually “dribble out” our position over time, taking advantage of market peaks where possible, while trying to avoid the dips. Every company is different, but it’s reasonable to expect the process to take 12 to 24 months for full liquidity.
Throughout this time period, our private equity fund holds publicly traded shares that are in the process of being sold. We are exposed to the volatile public markets, and as a “recent IPO” stock with a smaller public float, are likely more volatile than the broader market. The volatility impact on our Fund increases with the size of the gain on our investment, since a bigger position has a greater impact on our overall returns. A larger gain can also reflect a more speculative IPO, with a softer foundation supporting its price, leading to greater volatility in the first year of trading.
Why would we take the extra time and accept the higher volatility of the IPO path? Because the price is really worth it! If a double or triple is available from private buyers, the price in an IPO can be much higher. Here’s an example from our current portfolio:
We invested a relatively small amount of capital in Pandora Media in mid-2009, through a fund established by Walden Venture Capital. By late 2010, we were offered FOUR times our original price from a buyer in the private market – a very nice return but below our view of the Company’s true potential. We decided to sell a quarter of our position to recover all of our initial capital, but hang on to the profits to ride for further growth. By June 2011, Pandora completed a successful IPO [NYSE: P] and our return at the IPO price was over TWENTY times. But we were locked in, as expected, by the normal IPO lock-up requirements. Beginning in 2012, we have been slowly selling out of our position, and have successfully sold approximately 40% of our initial position as of mid-April 2012.
But with this kind of gain, even a small initial investment has added significant volatility to the NAV of our Fund. Since the IPO, Pandora has been a very volatile stock, trading in the range of $8 to $20 during a 9-month period, so the cost of hedging is prohibitive. We continue to sell shares as the market allows, but it takes time, and we have to accept the resulting volatility as we work our way through the sale process.
The key point is that this is what private equity success looks like. We would all love to invest in more deals with this type of return. We can get doubles and triples from M&A sales to strategic buyers, but it makes sense to tap the public markets – and accept the higher volatility – when we get true homeruns! |
