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 Thomas Bonney, the founder and managing director of CMF Associates LLC, comments on the return of the small-cap IPO as an exit alternative. "Welcome back. Your dreams were your ticket out." As the lyrics of the "Welcome Back, Kotter," theme song bounced over the speakers at a Philadelphia restaurant, I was struck by their relevance to an emerging trend for midmarket CEOs I'm hearing about in buyout and Wall Street circles: the potential "welcome back" to the small-cap IPO as a competitive exit alternative to the ongoing leveraged buyout cycle.
The Kotter theme continues, "Welcome back, to that same old place that you laughed about." I'm sure this line echoes the knee-jerk sentiment of many. Granted, with the required regulatory and legal hoops, why would any midmarket company look to the public markets as an exit possibility? In the current deal environment, any port in a storm could hold appeal.
And for certain business types, the initial public offering could offer funds the best return. Many midmarket companies are now into their second and third turn at the LBO process, during which each successive fund owner optimizes different aspects of the business. The cycle typically plays out like this:
In the midmarket subset described above, the funds have completed a decadelong job of professionalizing, growing and preparing family-owned businesses to graduate to the public markets. In this scenario, here's what we see as leading indicators for the small-cap IPO's resurgence as an exit: Lower LBO prices. Bank underwriters are now less generous with capital, which negatively impacts the ultimate LBO price. More manageable compliance. American businesses have digested the pain of Sarbanes-Oxley, and the continued pushback of the Public Company Accounting Oversight Board's compliance elements for small-cap internal control audits suggests small-cap firms will be, rightfully, exempt from many SOX rules. Cost-effective public market return. Increasingly, anecdotal data points indicate the current unlevered cost of capital for private equity exceeds the public market's equivalent cost of capital. Theoretically, the public markets could pay a higher price than private equity and still provide a desirable risk-adjusted return to investors. Capital costs also tend to favor a buyout by much larger publicly traded strategic companies seeking bolt-on acquisitions, partially by issuing stock. Shares scarcity. The combination of go-private transactions and corporate share buyback schemes over the past few years have decreased the actual number of shares available for purchase on U.S. exchanges. As the commodities markets illustrate, decreasing supplies generally lead to higher prices that could enhance the financial viability of an IPO exit. Global expansion strategies. The next growth spurt for more mature middle-market companies will likely be global market-driven, which brings a heightened level of risk and opportunity more appropriate for a public company investment. The IPO's weakness is it will not allow the seller to get completely liquid with its investment -- a strong motivation to opt for a purely cash or Spac deal in many 2008 buyouts. However, for a third-LBO-cycle company with first- or second-year investors, the IPO presents compelling potential to take capital and some profits off the table early and go along for the ride with the general public. In the midst of the financial angst that surrounds us, a "welcome back" to the small-cap IPO could provide certain private equity funds with an attractive new ticket out. Thomas Bonney is founder and managing director of CMF Associates LLC. Categories Deal Video
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