The Declining Attractiveness Of An IPO As A PE Exit Channel

The closing price of Chinese online retailer Vipshop (VIPS, NASDAQ) on March 30 was $4.35, down by 33% relative to its issuing price of $6.50 and bringing Sequoia Capital, one of its main investors, to the brink of book loss.
 
Vipshop’s performance has shocked venture capital and private equity funds that have historically earned healthy profits from IPOs, demonstrating that an IPO does not always equal making money. It has also chilled other domestic enterprises and their investors, who have been watching and waiting to see the results of overseas IPOs. The seven-month “Ice Age” of Chinese overseas IPOs has not broken since Tudou’s (TUDO) initial public offering on August 17, 2011.
 
The first quarter of 2012 has been witness to a significant decrease in the average book return for VC and PE exiting via overseas IPO. The average book return of IPOs on the NYSE retreated from 9.49 in Q1 2011 to 1.90 in Q1 2012, a nearly 80.0% drop.

Average book return for VC/PE exiting via overseas IPO

In addition to the credit crisis, a fading fanaticism for the “China Concept” has also contributed to the fall in valuation, and this puts ants in investors’ pants. Thanks to the previous positive expectation of high IPO returns, investors pushed up the valuation of companies in the primary market. Now returns are dropping, liquidity is decreasing, and the bad news does not lie only in the other side of the Pacific Ocean.

Let’s look at the 2011 P/E ratio of IPOs in China.

 
Although the P/E ratio for IPO stocks in China was very high in both January and December of last year, it plunged vertiginously across three stock exchanges from one month to the next, with ChiNext seeing the most significant decrease.
 
The book return situation in China fared even worse, with book return of IPOs on the Main Board slumping from a stunning 264.37 to 5.95.

Beginning in the second half of 2011, the pace of domestic Chinese IPOs slowed significantly; except for last August and September, there were no more than 20 IPOs each month in 2011. This year, the number of IPOs in January and February has been less than half that of the same period last year. Exiting is becoming more and more difficult for VC and PE.
 
The CSRC recently unveiled a new policy governing PE investment in companies one year or less before their IPO, requiring complete information disclosure and qualification check (we blogged about it last month). The new rules aim to identify special purpose vehicles (SPV) that are set up only for investing issuers, namely “fake PE,” effectively declaring the end of the pre-IPO investment model.
 

The combined factors are pushing VC and PE to find new exit channels, with mergers and acquisitions becoming an interesting alternative.

 
On March 12, Youku and Tudou announced their impending merger, widely suspected to be at their investors’ discretion. If share price of an investment isn’t performing well, why not propel an M&A between listed companies? Proving the point, Tudou’s share price went up by 178% right after the announcement, resulting in a $70.7 million book gain for IDG Capital Partners and a $74.6 million book gain for GGV Capital. Another example is the March 2nd acquisition of a 55% share of Luye Pharma by CDH Investments, CITIC PE, and New Horizon Capital from MBK Partners. Between January and November 2011, there were 299 exit transactions in China, of which 52 transactions were M&A.

 
Globally, in developed markets like Western Europe and North America, exiting via IPOs only accounts for 1% and 9% of exits, respectively, while trade sale and M&A are mainstream. Even in the Asia Pacific market, which includes China, IPO as an exit is not popular. IPOs are only popular in the BRICs, but even there trade sales are more frequently seen, an indication that IPO as an exit is rare in countries other than China, considering that IPO is the dominant exit channel in China.
 
Venture capital and private equity firms are currently is recruiting M&A talents, and while M&A was not popular in the past due to uncertain property rights, as the macroeconomic environment evolves, the general trend for exits will move towards mergers and acquisitions.