Case 084Portfolio operations and exitsHard

Exit a portfolio company by IPO at 20x earnings, selling 25% now with a 12-month lock-up and a 10% discount, or by trade sale now at 11x EBITDA? Compare value and timing to the fund.

The situation

Aranyak Outdoor Gear, a maker of tents and trekking equipment the fund has held for four years, earns net income of Rs 60 crore on EBITDA of Rs 100 crore and carries net debt of Rs 150 crore. Two exits are on the table.

Bankers say an IPO would price at 20x earnings less a 10% discount to get the book covered. The fund could sell 25% of its shares in the offering and the rest only after a 12-month lock-up, at whatever the market price is then. Alternatively a strategic buyer will pay 11x EBITDA today for 100%. The fund discounts uncertain future proceeds at 15%.

Your task

Work the proceeds under each route, put them on a common footing, and recommend one to the investment committee.

Quick check

The IPO prices the equity at a higher number than the trade sale. Is it the better exit?

Worked solution

Try it on paper, then open one step at a time.

30-second answerThe answer to give first

Take the trade sale unless the committee has a strong view on the share price a year out. The IPO values the equity at Rs 1,080 crore after the discount, but only Rs 270 crore arrives now; the Rs 810 crore remainder is a year away at an unknown price, worth about Rs 704 crore today. The IPO's present value is about Rs 974 crore against Rs 950 crore for the trade sale, and a 3.5% fall in the share price over the lock-up wipes out the difference.

Step 1What does each route actually pay, and when?

Put both on the same line: equity value, in cash, on a date. Selling a house to a buyer with a cheque today is not the same as listing it with an agent who sells a quarter now and the rest next year at next year's price. The IPO values the equity at 20x Rs 60 crore, Rs 1,200 crore, less the 10% discount, Rs 1,080 crore; the trade sale values the enterprise at 11x Rs 100 crore, Rs 1,100 crore, less Rs 150 crore of net debt, Rs 950 crore of equity. The IPO headline is 14% higher, and on an enterprise basis it is about 12.3x EBITDA. But the trade sale pays all of it now, and the IPO pays a quarter now and three quarters after twelve months.

When the money arrives: trade sale at once, IPO in two tranches a year apart, Rs croreTrade sale at 11xmonth 0month 6month 12950100% sold, cash in hand, doneIPO at 20x P/E, 10% discountmonth 0month 6month 1227025% sold810?75% after lock-up, at the price thenHeadline 1,080, but 810 of it is a year away and unpricedAt a 15% discount rate the IPO is worth about 974 today against 950 for the trade sale: a gap of 24 before fees.
The trade sale delivers Rs 950 crore at once; the IPO delivers Rs 270 crore at listing and Rs 810 crore only after the lock-up at a price not yet known, so its Rs 1,080 crore headline is worth about Rs 974 crore today at 15%.
Step 2How do you put a year of uncertainty on a common footing?

Discount the delayed tranche at a rate that reflects what a listed small-cap can do in a year. At the fund's 15%, Rs 810 crore in twelve months is worth Rs 704 crore today, so the IPO route is worth about Rs 974 crore against Rs 950 crore, a lead of Rs 24 crore. Then ask how robust that lead is: the IPO beats the trade sale only if the share price at the end of the lock-up is within 3.5% of the issue price. Newly listed small companies routinely move more than that in a year in either direction, so the lead is inside the noise. Underwriting fees of around 4% on the first tranche take it down to about Rs 964 crore, and a second placement after lock-up will cost another discount.

How far the share price can fall before the IPO is worth less than the trade sale, Rs crore90095010000%5%10%15%20%25%Share price fall from the IPO price to the lock-up expiryTrade sale: 950 now, certainBreakeven:a 3.5% fallerases the leadIPO, no price fall: 974
The IPO's present value falls as the share price falls over the lock-up, and crosses the trade sale's certain Rs 950 crore at a fall of only 3.5%; the IPO's headline advantage is thinner than the multiples suggest.
Rs croreTrade saleIPO
Valuation basis11x EBITDA, 100% control20x earnings less 10% discount
Equity value9501,080
Received at month 0950270
Received after 12-month lock-up810 at the price then
Present value at 15%950974
Price fall that makes them equal3.5%
On a present value basis the two routes are Rs 24 crore apart, about 3%, and the IPO's advantage disappears if the shares fall 3.5% during the lock-up, before counting fees or the discount on the second sale.
Step 3What do you recommend, and what would change it?

Recommend the trade sale. It converts the whole position to cash now, carries no market risk, and pays a control premiumThe extra a buyer pays for 100% of a company, because owning all of it lets the buyer run it, merge it or sell it. that an IPO, which sells minority stakes to the market, never does. The IPO wins only if the committee believes the company will re-rate after listing, say because earnings grow 25% during the lock-up and the market keeps the 20x multiple, or if the fund wants to keep exposure to a business it thinks is early in its growth. Those are legitimate views, but they are views about next year's price, and the committee should hear them stated as such. Say also that the IPO leaves the fund as a 75% holder of a listed company for at least a year, with reporting duties and a stake it can only sell in blocks at a discount, which is a cost of the route that the multiples do not show.

Where candidates lose it

The usual loss is comparing 20x earnings with 11x EBITDA as if they were on the same basis. One is a price for equity, the other for the enterprise; convert both to equity value, in cash, on a date, before saying which is higher.

The second is treating the lock-up tranche as money. Three quarters of the IPO proceeds are a hope about next year's share price, and a candidate who does not discount them, or at least name the risk, has recommended on the headline.

What the interviewer asks next

  • Earnings are expected to grow 25% in the lock-up year and the multiple to hold. Which route now?
  • The strategic buyer offers 11x but wants a two-year earn-out on 20% of the price. Does the IPO win?
  • Why might a fund choose an IPO even when the present values favour a trade sale?

Company names and figures are illustrative.