I wrote this several years ago but thought the SM community would like the story. sorry it is a bit long.

Many years ago I was a senior analyst with a major institution in Sydney. Part of its extensive equity portfolio was an unlisted investment. How an unlisted investment came to be in the portfolio in the first place is another story but now I was responsible for this investment, so I closely examined its prospects.

As a shareholder in the venture we had access to the board papers and budgets. The firm was basically an ice cream factory. Examining the past papers I quickly came to the conclusion that the firm was struggling and we would be lucky to avoid writing down the investment. The accounts told the tale, continual operating issues, losses, and negative cash flow. Troubles with manufacture, distribution, market positioning. The situation looked dire. I thought we had done our dough.

The broad strategy appeared to be if the firm could string a couple of good results together it would be promptly floated on the ASX, thereby providing a profitable exit. No sooner as I had scoffed at the likelihood of this plan succeeding, the situation changed dramatically. As if by divine intervention everything in the business suddenly fell into place. Budgets were met, operations performed, distribution was near faultless. I was accordingly gob smacked.

Promptly the plan to float was quickly put into place. The firm was given to an underwriter, future earnings projections estimated which portrayed a positive future of increasing earnings over time. The firm was successfully listed and celebrations had. Again, I stood amazed as it floated at a price that shortly beforehand would have been unimaginable. The process was assisted by a strong bull market.

Soon afterwards the issues that had plagued the firm beforehand reemerged. The share price fell and management was questioned etc. etc. To me it all appeared as if nothing much had changed except that there were now new owners at a higher price that could fear over the same issues I had agonized over not long before. The company ended being bought for crumbs by a competitor.

The experience of this leveraged buyout, what would now be called a private equity firm, left a lasting impression on me that would permeate through my investing career. That is, a deep skepticism of floats brought to the market by incentivized sellers.

There is something about a sale from a professional investor that is quite different from, for instance, a sale from the government or a sale from a company to its shareholders, or a sale forced by consequence. The private sellers are highly incentive to maximize receipts. In fact they would be quite unhappy if new investors made a windfall for that would imply that they had sold the firm too cheaply. Other sellers may not be so incentivized.

Years later a top 100 CFO would describe to me dealing with PE firms as being incredibly intense. Their skill, in his opinion, was only on achieving a low purchase price and maximizing their exit price. His view was that was the only value they added to the transaction, but that they were very good at it.

If we assume that an owner is highly incented to buy low and sell high what possible actions could the owners take to maximize short-term profit, potentially at the expense of long-term profits and therefore maximize sale proceeds. The aim is to engineer current earnings, that is, what the company is being sold on, to be as attractive as possible. All within accepted accounting rules.

The list unfortunately is quite long. A non exhaustive list may include, cutting research and development, cutting sales staff or marketing, raising prices, entering into low start payment or loans, changing depreciation, lowering investment in plant and equipment or inventory. The aim of all this is to increase short-term profits at the expense of long-term profits. The new owners would at some stage have to spend up to cover these shortcomings. Profits would likely be over stated when the firm came to market.

So we come to two of the high profile floats over the last ten years, the float of Myer and the float of Dick Smith. Without any judgment of the issues above what could be observed about these companies from history. Many years ago I spoke with John Fletcher who was managing Coles but I knew from being CEO of Brambles. I asked him how different was the management task at Coles Myer. Part of his answer was commenting that Myer was 10% of the revenues but 50% of the problems!

Any cursory look at the accounts would have come to the same conclusion. Myer was an issue and had been so for years. With revenues and profits moving all over the place, there was even a theory that department stores were no longer relevant to the new retailing world. Coles finally sold the firm to PE but soon after it came back, sparkling new and transformed.

The valuation between the purchase price (low) and sale price (high) was stark. The obvious question was had fundamentals changed that much? Could the future prospects of Myer be that different over a relatively short period of time? Could management have permanently improved the operation by that degree?

Like most PE floats there is a huge marketing campaign accompanying the sale process. Dick Smith would follow an erringly familiar course several years later. The similarities were quite uncanny. Poor operation taken into the PE conversion chamber, churned out relatively quickly into a moneymaking machine. The sellers in both cases had been seasoned retailers.

Everything in investing is easy in hindsight. We are all wise with the results fully disclosed. Over the time involved here I analyzed countless prospectuses, but not by coincidence I can say that Myer and Dick Smith were not two of them.

Is it reasonable for a witch-hunt to be run against PE floats?

Of course not, the job of the professional investor is to analyze the information at hand. Including judging whether there is enough information disclosed to determine whether the issues mentioned above are not being used to pretty up results.

There have been great performances from PE floats and disasters however the base case is that you are dealing with professional sellers who are highly incented to maximize sale prices and drum up a frenzy of excitement to maximize sale proceeds.

If you cannot deal with this situation then hire someone who can. Of course I am not suggesting that all professional investors are up to the task!   

As an aside if you were really being offered such an attractive opportunity surely the sellers would be open to attaching a, say, two year put! Lol. Think about it.