Trouble ahead for private equity sellers

NEW YORK (CNNMoney.com) -- Buyout firms have binged on deals over the last few years, but they may face some difficulty when it comes to finding a way out of their investments.

Taking the companies they own public is one route open to private equity investors - one that's been gaining momentum.

But private-equity-backed initial public offerings could very well get a decidedly cool reception from investors, despite a hot market overall for initial public offerings. IPO volume so far this year is at its highest level since 2000, right before the tech bubble burst.

Buyout firms have been taking companies they own public at a swift pace. Last year, they got back about $33 billion from initial public offerings, up 25 percent from 2005, according to deal tracker Dealogic.

Just this week, movie theater chain Cinemark, partly owned by private equity firm Madison Dearborn Partners, went public in a $532 million offering.

Marquee Holdings, which owns AMC Entertainment, is set to hit the market next week. Marquee's owners include buyout firms Apollo and JP Morgan Partners, the former private equity division of JPMorgan Chase (Charts, Fortune 500) that was spun off as CCMP Capital last year.

Private equity firms typically acquire mature companies with the aim of restructuring them to make a profit. They usually hold companies for a few years before they "exit," usually via a public stock offering or sale to a corporate buyer or another private equity firm.

Public offerings accounted for about 15 percent of exits by buyout firms globally last year, Dealogic figures show. But many industry experts expect private-equity-backed IPOs to increase in the next few years, mainly because the size and number of buyout deals has exploded: the biggest deal this year was the record $45 billion buyout of TXU Corp (Charts, Fortune 500).

"For a lot of the mega deals, there just aren't many logical strategic buyers," Mark Williamson, managing partner of Calera Capital, said this week at a private equity conference sponsored by industry publication The Deal.

Investors, however, are showing some wariness over such offerings. Cinemark, which was taken private by the company's management and Madison Dearborn in 2004, went public without much fanfare this week. Cinemark (Charts) stock closed a shade below its $19 offering price on Tuesday, the first day of trading, and has only crept up slightly since then.

"What we're seeing here with Cinemark may be a precursor to an era of caution that may grip investors moving forward for these types of deals," said David Menlow, president of IPOfinancial.com, an independent research firm.

He expects the pace of IPOs that are backed by private equity to increase. But IPO investors will "at some point show the private equity market that they've had their fill of these deals," said Menlow.

Critics say private equity buyers "flip" companies after loading them up with debt - without doing much to improve operations - while lining their own pockets. Private equity firms, meanwhile, assert they make operational improvements that boost performance and add value.

A study published last year by Harvard Business School finance professor Josh Lerner and Boston College's Jerry Cao found that, on average, buyout-backed IPOs consistently outperform other IPOs as well as the broader market. But companies that went public within a year of being taken private were an exception to that finding, the study showed.

Private equity buyers say they aren't in the business of flipping companies. Building a company and improving its performance takes time, they note. And, for the record, both Cinemark and Marquee were held by private equity buyers for about three years before going public.

But some private equity firms may be getting impatient. There has been speculation that Texas Pacific Group and Warburg Pincus - the duo that bought Neiman Marcus two years ago for $5.1 billion - are considering taking the upscale department store public later this year. Texas Pacific and Warburg declined to comment.

How investors react to the new wave of private-equity-backed IPOs essentially comes down to an issue of quality, experts said.

With the heated market for IPOs, investors can be more selective these days. U.S. IPO volume has risen to $15.5 billion so far this year, up 14 percent from a year ago, according to Dealogic.

"Given the volume of IPOs and rising average deal size of the IPOs that are coming to market - a company's performance is important," said Maria Pinelli, leader of Ernst & Young's Americas Strategic Growth Markets division. "Investors are expecting great returns," she said.