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Party City IPO Tests Private Equity Industry Carousel

NEW YORK (TheStreet) - Party goods retailer Party City was solidly profitable when the company was gearing for an initial public offering in May 2012. Nearly two years later, the company is again attempting an IPO. This time, however, Party City is losing money and its debt has more than doubled to over $2.3 billion.

In the intervening time, Party City's former private equity owner's Advent International, Berkshire Partners and Weston Presidio sold a majority of the company to another PE firm, Thomas H. Lee Partners, in a $2.7 billion deal that required about $1.5 billion in debt financing. The deal, called a secondary buyout on Wall Street, allowed Party City's former owners to trim their investment in the company and gave THL one of its biggest deals since the financial crisis.

Now, Party City's newest attempt at an IPO may give ordinary stock investors a major glimpse into a subtle shift in the PE industry, which could become an investible trend in coming years.

The IPO could indicate whether companies changing hands among PE buyers in recent years have become damaged by that financial maneuvering. In the case of Party City, rising debt, high interest expense and net losses standout as issues that stock investors now have to consider, in contrast to the company's 2012 IPO filing.

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Party City's IPO may also be on the vanguard of a wave of secondary buyout deals, particularly in Europe. THL's takeover of the company in June of 2012 came midway through a record year for secondary buyouts, according to data from Preqin.

One private equity executive, Joseph Baratta of The Blackstone Group (BX - Get Report), recently highlighted the high volume of secondary buyouts in Europe as a concern for the PE industry.

"Right now in Europe, something like 75% of deals above $500 million in enterprise value are sponsors selling to each other- that's not a sign of health in our market," Mr. Baratta was quoted as saying at a Bloomberg conference  in London last October.

The popularity of secondary deals in recent years is no surprise.

PE funds generally look to hold onto their investments for five-to-seven years before looking to exit and return capital to their investors. However, corporate buyers and IPO markets have only recently begun to be a healthy means for PE firms to exit their investments. Secondary PE buyers, flooded with unspent cash in their funds and access to record cheap financing have often proven a better alternative.

That may have been the situation in Party City's case. The company pulled its IPO just a month before selling a majority of its shares to THL Partners. The decision, however, impacted Party City's financial results.

In 2011, the company earned a net profit of $76 million on $1.85 billion in revenue. Total debt at Party City stood at less than $1 billion. Fast forward about two years and Party City's results for the first nine months of 2013 show a net loss of $52 million, or a $9 million loss when accounting for pro-forma adjustments that account for the company's IPO.

Party City's rising debt from the 2012 transaction plays a major part. In 2011, annual interest expense at the company came in at about $77 million. Through just the first nine months of 2013, Party City's interest expense stood at $103 million, wiping out all of the company's operating profit, and then some.

The leverage and financial engineering embedded in PE deals has long been a lightning rod issue for buyout funds. However, the criticism of the debt levels in PE-backed IPO's has also proven a disconnect that's generated opportunity for some investors.

Debt fueled mega-buyout deals once considered duds like KKR's (KKR) buyout of hospitals giant HCA (HCA), the takeover of Kinder Morgan (KMI), HD Supply (HDS), and Blackstone's purchase of Hilton Worldwide (HLT - Get Report) have all exhibited strong performance on public stock markets since going public. Corporate buyers of other pre-crisis buyouts like Walgreens (WAG) acquisition of Alliance Boots, Valeant Pharmaceuticals (VRX) acquisition of Bausch + Lomb and, most recently, Sysco's (SYY) acquisition of U.S. Foods have all been taken well by public shareholders.

Investors looking beyond the high debt levels of each of those companies has been rewarded, especially in an interest rate environment that has allowed firms to refinance their high cost debts and deleverage their balance sheets over time. Private equity mogul Steve Schwarzman of The Blackstone Group recently said he personally thanked former Federal Reserve chair Ben Bernanke for the buyout giant's stellar returns in 2013. 

It's no surprise why he's happy. Blackstone's private equity investments made some of their best-ever returns in 2013. Things have gotten so good it might even be hard to remember white knuckle restructurings, for instance Hilton Worldwide, that occurred just a few years ago. 

But Party City's IPO may be more indicative of the future.

If markets spent recent years in another credit bubble, as some suggest, it is PE secondary buyouts that may exhibit the biggest symptoms.

Investors buying into Party City's IPO, however, are likely to expect a similar deleveraging story that has played out in similarly debt-laden deals. Other metrics at the company are also trending in a positive direction.

Party City's adjusted earnings before interest, taxes, depreciation and amortization have grown from $21 million in the first nine months of 2012 to $145 million during the same period in 2013. EBITDA deducts things like interest expense and is a preferred metric of PE investors.

It will be interesting to watch the pricing of Party City's IPO as a read on whether investors are willing to put their money behind secondary buyouts. So far, taking issue with the high debt levels of deals hitting stock markets has proven to be more of an alarmist concern for those covering the private equity industry.

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