Casting a Cautious Eye on Private-Equity IPOs

Retail investors wanting a piece of high-rolling private-equity action should look cautiously at a novel pair of initial public offerings from giant buyout firms Kohlberg Kravis Roberts and Apollo Investment Group, as underwriting firms move to get a share of the lucrative market.

Seen as the advance guard of a movement expected to sweep through the private-equity industry, the two multibillion-dollar firms created closed-end, public investment companies that will make private investments in middle-market companies. These mezzanine debt funds will generate income through debt, and eventually, stock in companies that are taken public.

According to a Securities and Exchange Commission filing, KKR's business development company will invest up to 30% of its portfolio in distressed debt, high-yield or junk bonds and other distressed securities of public companies.

Apollo raised $930 million and closed its doors to new money after pricing an IPO for its Apollo Investment Corp. ( AINV) on April 5. KKR filed a $750 million offering Monday that could raise well over $1 billion, according to industry observers.

But David Menlow, president of IPOFinancial.com, said investors won't see the quick gains and high stock turnover once equated with initial public offerings. While the new securities are public, investors in the third- and fourth-largest IPOs of the year should go in with a whole new set of expectations, he said.

"Investors coming into these deals have to just let go of whatever objectives they have for the short term," he said. "This is all about trusting Apollo or KKR. It's 'Let's put our faith with them.' It's a longer-term view, not something where you're going to buy these stocks and get a pop at the opening."

Apollo Investment shares closed at $15.04 on Tuesday, and have reached only as high as $15.44 since they started trading April 6.

Robert Kyle, executive vice president of PlacementTracker, says private-equity investing is very different from buying stocks. While the novelty of getting into these deals may be appealing, it's also very complicated.

"It's probably a bit of a trend, these alternative investment vehicles getting exposed to the public markets -- it gives investors a chance to do things they normally can't do," he said. "But I think the biggest question mark here is: Will the average investor be able to understand what they're buying here?"

Absolutely not, said one long-time private-equity expert, who asked not to be identified.

"In my view, they're incredible sucker bets," he said. "These offerings are loaded up with fees and underwriter spreads and it's incredibly stupid."

Menlow said the underwriters of these offerings were set to reap significant revenue from the customary 6.25% commission for the listings. UBS Investment Bank, a unit of UBS Group ( UBS); J.P. Morgan Securities, a unit of J.P. Morgan Chase ( JPM); and Citigroup ( C) led the Apollo deal. Credit Suisse First Boston, a unit of Credit Suisse ( CSR) and J.P. Morgan Securities handled the KKR listing.

"It does appear to be the underwriting companies' opportunity to share in the fees that are going around," he said. "This is the world of the brokerage community trying to capture a piece of that market."

Other private-equity firms have been approached by underwriters who hope to swing similar deals, but none have announced their plans.

In addition, the anonymous industry expert said KKR has no history of distressed-debt investing.

"They're raising the fund totally on the name of KKR, as opposed to some long-term historical record of these kinds of investments," he said.

Apollo expanded its distressed debt investing last year, launching a $650 million hedge fund to make those investments.

Typically, investors in private-equity funds commit large amounts of money -- usually a minimum of $5 million for institutional investors -- provide capital when the fund asks for it, and wait as long as 10 years to see a profit. The private-equity fund takes 20% of that profit, usually after it reaches a previously agreed-upon profit percentage, often called the hurdle rate.

Despite differing track records, the two private-equity shops have one thing in common: They both want to raise as much money as they can as quickly as possible, and the public offering shortcuts a private fund-raising process that can take up to a year.

"It's weird that the private-equity industry has glommed onto this method of fundraising, but look at the dichotomy between this and the difficulty of raising a fund in the private market," the industry skeptic said. "It's difficult to raise a mezzanine fund privately, and it takes a long time. I would contrast that with the ease with which Apollo and KKR are seemingly going to pull off the public thing."

"I bet everybody's going to be doing one of these deals now," Kyle said. "The appetite is there."

Menlow said the need to defer the expectations of quick money may go some small way to ending investors' notions for newly listed companies.

"It's just pushing everyone back to the strict definition of what IPO investing is all about," he said.

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