The rise and fall of electronics giant Dick Smith

HERE'S a handy investment tip - never buy anything from a private equity firm.

Last Monday shares in electronics retailer Dick Smith fell close to 60 per cent after it revealed the stock it has in its stores and warehouses is worth A$60 million less than it thought.

That was quickly followed two days later by news that cleaning and catering group Spotless had failed to win contracts it was expecting in the resources sector, sending its share price down 40 per cent.

(Interestingly, Spotless does the catering at the New Zealand Parliament, a contract it lists in the "Leisure, Sport and Entertainment" section of its website.)

What these two events have in common is that they were floated on the Australian share market by private equity companies in the past couple of years.

The way private equity funds operate is by buying up a troubled business with a little bit of their investors' money and a lot of bank debt. They'll manage the company for a couple of years and "turn it around" by sacking staff and cutting costs. Then when the financials start to look a bit better they'll float the business on the share market and pocket the vast proceeds, sometimes funnelling them through an overseas jurisdiction with, shall we say, more gentle tax rules than our own.

It's akin to selling a used car. A good clean, some new tyres, fix a couple of dings and that clapped out old banger is suddenly looking a lot better. (I'm sure they never wind back the odometer.)

Dick Smith and Spotless have both trod a well-worn path of private equity share market sales.

The companies usually perform well for a year or two after listing before the bad news hits. And some time after listing but before the bad news, the private equity owners get rid of their remaining shares in the business.

Dick Smith was bought from Woolworths by Anchorage Partners in late 2012 for A$74 million and floated a year later with a valuation of A$345 million. About a year after that Anchorage sold its remaining 20 per cent in the company.

The private equity firm pocked close to A$370 million from the Dick Smith business thanks to initial share price gains. Meanwhile investors who paid A$2.20 a share when the business floated would have been somewhat distressed to see them drop as low as 22c each last week.

Spotless was bought for about A$720 million by Pacific Equity Partners in August 2012 and then put back on the share market with a valuation of about A$2 billion less than two years later.

The last of Pacific Equity Partners' shares in the business came off escrow (meaning they couldn't sell them) on August 25 this year, and they sold them the day after. When Spotless floated, investors bought them for A$1.60 each. They had been trading comfortably above than until last week's profit warning, when the dropped to around A$1.30 each.

Another feature of private equity sales is that management doesn't hang around too long. In the case of former Spotless CEO Bruce Dixon, he left the company in late November, just days before the bad news hit.

Defenders of private equity will point to successful floats that have made money for investors, and while there are exceptions, it's fair to say the private equity model hasn't always been good to share market investors.

It is perhaps a little too easy to blame private equity funds alone for this state of affairs, because investment banks usually get involved in pushing the shares onto investors.

Private equity funds exist for the benefit of their investors and in that respect they usually perform very well. Their role is not to provide easy profits for subsequent owners of their investments.

Investors weighing up a private equity float would do well to remember that these funds are run by hard-headed bankers and managers who know how to wring every last cent out of a business. There won't be any easy gains left on the table for subsequent investors.

Finally, if they do take the plunge, investors should take their cue from the original private equity owners. When the private equity firm sells down its stake in the business, that's usually a pretty strong signal to do the same.

Christopher Niesche is a Sydney-based business journalist. He is a former editor of the Business Herald and a former deputy editor of the Australian Financial Review.



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