Cornerstone investors: Public market props

When AVCJ approached PAG for comment on its cornerstone investment in the $1.9 billion IPO of Chinese brokerage Haitong Securities, the private equity firm declined to be interviewed. So did Saban Capital, which anchored the listing of Indonesian pay TV operator MNC Skyvision earlier this month, while Baring Private Equity Asia, SAIF Partners and Sequoia Capital were no different.

It was unsurprising. Each of these firms has at one time or another portrayed themselves as a master of operational value-add. While each has their motives for becoming a cornerstone investor in an Asian IPO, none wants to go on the record to defend why they did so.

The main reason is presumably a fear of upsetting LPs. As Christopher A. Laskowski, COO of corporate and investment banking for Asia Pacific at Citi puts it, "a lot of the bulge bracket LPs are very sensitive to this issue."

Indeed, most LPs expect the private equity investors they work with to participate in situations where public investors cannot; they want GPs to do private-level detailed due diligence, they want governance rights, value-add, and an influence on the company - if not control. Though most LPs would shy away from cornerstone opportunities due to the size of the contribution required - PAG, for example, stumped up $300 million to back Haitong's listing - they could in theory do these deals without a fee-charging intermediary.

LP discontent

"No LP really likes it too much if a GP goes into an IPO situation, rather than exiting via an IPO, because the eternal question is: Why do I pay a 2% management fee and 20% carry to invest in a publically-listed company? That's not what private equity is for," says Markus Ableitinger, Capital Dynamics' managing director and co-head of Asia Pacific private equity. Capital Dynamics counts Baring, which covered a large chunk of China Yongda Automobile Services' Hong Kong offering, among its investees.

An exception to this is D.E. Shaw, strictly speaking a hedge fund with private equity exposure. It acted as a cornerstone alongside PAG and 10 others in the Haitong IPO. "Unlike traditional, stand-alone PE managers, the D.E. Shaw Group is a global multidisciplinary manager with investments in both public and private markets. This gives us the ability to analyze cornerstone private transactions from the point of view of a public markets participant," Donald Tang, head of Greater China Private Equity at the firm, tells AVCJ.

Aside from the perennial debate as to whether PE firms should charge fees for making public market investments, another issue for LPs is the greater number of variables that can impact the success of IPOs. The range of downside protections GPs can negotiate on a private transaction - such as put options and other instruments to fix the price - usually aren't available on public deals. External factors can often influence the movement of the public company's stock in a way that is beyond the investor's control. When that happens, it leaves the shareholders unprotected.

Because of this, there needs to be a strong argument to do such a deal. Several firms seem to have found one of late though, as according to Bank of America Merrill Lynch, PE funds have made up 41% of cornerstone investors in Hong Kong IPOs so far in 2012, compared with just 5% last year.

The companies attracting cornerstones don't seem to be restricted to one particular sector either - Asia Pacific firms from the finance, mining, oil and gas, machinery, energy and consumer sectors, among others, have benefitted.

Tempting valuations

The most compelling driver of PE's participation is the valuation at which cornerstones can come in on IPOs, when compared to the current pricing of private companies. Though a cornerstone investment 3-4 years ago probably wouldn't have made any sense due to the stratospheric public market valuations, today the reverse is true. Private valuations have been slow to come down, while equity markets have suffered amid uncertainty surrounding the euro zone, and economic growth in the US and China, respectively.

In addition to maintaining the high private valuations, the dry power held by these funds has seen a number of larger players turn to IPOs as a way of deploying large amounts of capital, fast. PAG is approaching a final close on a $2.5 billion fund; Baring raised $2.4 billion last year; and KKR, which backed the Hong Kong IPO of China Outfitters, is said to be approaching a first close of about $3 billion on its new $6 billion Asia fund.

Cornerstone investors have an advantage over their PIPE counterparts as well. Not only can they exert some influence over the valuation they come in at and the structure of the deal - as companies that want to issue their shares successfully feel obliged to heed cornerstone requests - but also, unlike with a PIPE transaction, prospective IPO investors have less of a benchmark to work off.

"In these IPO cornerstones, there is no public market for these companies, so the PE fund can get comfortable buying in at a relatively low valuation, but if it was a publically traded company at a higher valuation, they wouldn't look at it," explains Laskowski, whose firm has worked on the IPOs of Haitong, Sun Art, which included General Atlantic among its cornerstones, and SAIF Partners-backed China Polymetallic over the past year.

Laskowski argues that rather than being a negative, having full due diligence carried out on a company to international standards by 2-5 bookrunners and a team of Big Four accountants is another plus for GPs that are considering backing IPOs.

PE firms' entry to this space also comes as a result of reduced activity among traditional investors. Hedge funds are noticeably less active than before, while high net worth individuals, spooked by the underperformance of IPOs since 2009, contributed just 2% to all cornerstone investments so far this year, down from 20% in 2009. PE firms have seized the opportunity.

"IPOs in general are more affected by short term market sentiment, but the PE investors tend have a longer-term view anyway, so short-term volatility isn't something that bothers them as much as it does a typical public market investor," says Kester Ng, chairman of Asia equity capital markets at JP Morgan Chase & Co. "If they buy in at 5-6x, they can get a decent position at a low valuation and potentially even with a board seat - they care less about short-term volatility because their typical private equity investment horizon could be 3-4 years or more."

The consensus seems to be that most firms are entering these companies for the long-haul, and have no intention of doing a quick flip of the shares once the six-month lock-up period ends.

There are other ways in which firms are attempting to align these investments with typical private equity practice as well: bookrunners claim that the brand name PE firms only seek to participate in IPOs of companies that fit their investment theses and have synergies with existing portfolio businesses. The more astute GPs aren't making investments in industries with which they're unfamiliar, and are insisting on getting a chance to know management and understand the business plan.

"Some sponsors are only focusing on cornerstones when they can add some significant influence: a board seat, observer rights, something where they're not just pumping money in and then walking away," says Laskowski. "They are looking for companies where they can get more active hands-on management."

While board seats aren't guaranteed at the time of making the investment, there is a strong likelihood that PE firms will gain a seat, as the other shareholders - high-net-worth individuals, hedge funds, sovereign wealth funds - want to trade freely on the stock and generally prefer not to have one.

Short-term phenomenon

Whether or not PE firms will end up making significant operational changes at these companies and ultimately view them as deals they are proud to discuss in public forums remains to be seen. Few believe that GPs' recent accelerated participation in IPOs is a trend that will continue much beyond the end of this year, or the first quarter of 2013, anyway. When the equities market springs back, IPO valuations will rise like the tide and it's anticipated that PE firms will withdraw from opportunities in this space and cornerstone tranches will reduce overall.

"This is a short-term phenomenon," says J.P. Morgan's Ng. "When sentiment improves and the IPO market reopens more broadly, PE firms will then move away from this area because it will coincide with valuations going up to more normalized IPO levels. We could see a rebound in the fourth quarter, but it's all very data and politics dependent."

 

SIDEBAR: Cornerstones - The key to IPO success

Cornerstone investors have become vital to the success of IPOs in Hong Kong where 75% of new listings since 2009 have underperformed the city's main stock index, according to FactSet. Citi estimates claim that up to 70% of Asian IPOs involved a cornerstone investor last year, and this figure is expected to rise to more than 80% in 2012.

Kester Ng, chairman of Asia equity capital markets at J.P. Morgan, puts it plainly: "Due to market volatility, the cornerstone process is currently a big part of ensuring a successful completion of IPOs in Asia. The more cornerstones you have, the higher the success rate."

The same could be said of the size of the cornerstone tranche, i.e. the more shares that are covered by cornerstones, the better the chances of launching a listing that thrives. Eight of the 15 IPOs that had taken place by May of this year saw 30% or more of the deal taken by cornerstone investors. Ng believes that up to 80% of transactions this year will be structured in this way.

Eight of the 15 $40 million-plus Hong Kong IPOs that had taken place by mid-July of this year saw 30% or more of the deal taken by cornerstone investors. J.P. Morgan's Ng believes that if the current market sentiment continues, the bulk of transactions this year will be structured in this way.

The trend in Hong Kong currently is for cornerstones to take 40-50% of an offering, rather than the 15-20% stakes of old. Fears of making the stock illiquid or having an insufficiently diverse shareholder base have been replaced by a fear of not completing the deal at all.

Sunshine Oilsands, which raised about $580 million through its Hong Kong IPO in February, took this practice to the extreme when it allotted almost 60% to its cornerstones: China Investment Corp (CIC), China Petrochemical Corp. and US asset manager EIG Global Energy Partners.

Citi, meanwhile, now considers its ability to market an IPO to prospective cornerstones as a crucial part of securing new listing mandates. The investment bank uses its broad network to gauge interest in anchoring deals: the private equity community; high-net-worth individuals through Citi Private Bank; sovereign wealth funds and state-backed firms such as Korea Investment Corporation and Korea Development Bank through its public sector group; and institutional funds from its equities desk.

"We've found Citi's platform to be a critical factor in getting organized for IPOs these days - getting a cornerstone investor on board is extremely important," says Christopher A Laskowski, COO of corporate and investment banking for Asia Pacific.

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• Topics
• PIPEs
• GPs
• PAG
• Baring Private Equity Asia
• IPO
• PIPE
• Saban Capital Group
• SAIF Partners
• Sequoia Capital