NEW YORK Private equity firms are finding that selling shares in a company they own is not exactly the same as exiting the investment.
Traditionally, private equity firms sell companies they own to public investors through an initial public offering. After the IPO and a few follow-on offerings the firm's investment in the company would be over.
But now, IPO investors are demanding that private equity firms hold their stakes in the IPO and use proceeds from the initial offering to pay down debt. That means that private equity firms are left holding the same amount of equity, and their only hope for exiting their investments is future follow-on offerings.
The trend could affect some of the biggest IPOs of the year, including Nielsen Holdings, best known for its TV viewership ratings; hospital operator HCA Holdings Inc; and retailer Toys R Us Inc.
Investors are looking for companies to reduce their risk by reducing their debt -- liabilities can push a company into bankruptcy if they can't be refinanced when they mature.
Profits also increase when a company no longer has to pay as much in interest.
"Paying off debt is something that investors are comfortable with," said Jay Ritter, a finance professor at the University of Florida.
Take Nielsen, for example. Its IPO is backed by private equity firms Carlyle Group CYL.UL, Blackstone Group LP (BX.N), Kohlberg Kravis Roberts & Co KKR.UL, Thomas H. Lee Partners, AlpInvest Partners and Hellman & Friedman, and is set to price a roughly $1.5 billion IPO at the end of the month.
It will be the first major buyout-backed IPO of 2011, and proceeds from the deal will go almost entirely toward paying off debt.
Like most companies that go private, Nielsen has a lot of debt. As of September 30 it had $8.6 billion, including lease obligations, compared with total assets of $14.4 billion.
Nielsen is not a fast-growing company, and paying down debt is likely its best bet for boosting earnings, said Nick Einhorn, an analyst at Connecticut-based IPO investment house Renaissance Capital.
"Investing the IPO proceeds in the business is not going to spur them into hyper-growth mode. As far as what can drive earnings growth it makes more sense to pay down debt," Einhorn said.
Paying down debt is also the top priority for private equity-backed HCA and Toys R Us, which are set to raise $4.6 billion and $800,000, respectively, in their IPOs.
Private equity firms buy companies mostly with borrowed money, which means that if sponsors exit their investment through an IPO, investors can be saddled with a heavy debt burden.
That is one reason buyout-backed deals have historically been a tough sell, despite the fact that the companies private equity firms tend to target are typically larger and have proven track records.
Casino operator Caesars Entertainment Corp, controlled by Apollo Management LP APOLO.UL and TPG Capital LP TPG.UL, scrapped plans for a $500 million IPO in November after investors and analysts raised questions about the IPO valuation and debt.
The company had a debt-to-earnings ratio of 10 before interest, taxes, depreciation and amortization, Einhorn of Renaissance said.
"They couldn't get the deal done largely because investors were concerned that they wouldn't be able to manage that debt burden," Einhorn said.
"That kind of concern has become more important since the financial crisis. There's a little more hesitancy to operate at those kind of leverage levels."