In theory investors should note the added debt and lower the price they are willing to pay for the IPO. Do they do this? Its hard to tell since we don’t know what the offering prices would have been without the debt. If investors are only looking at multiples such as P/E ratio, then the reduction in share value will be a function of how much the added interest expense affects earnings.

Should private equity ownership before an IPO be a reason per se for selling short a company? No. The company should be viewed on its fundamentals: valuation, riskiness of its indebtedness, sales prospects, likelihood of insider sales, etc. All things equal, private equity investors may be a good thing for a company if they provide management expertise or are especially vigilant about their investments. Some private equity investors are adamant that they look after their portfolio companies in ways mutual funds and other institutional investors can’t. On the other hand, private equity firms are getting larger and larger and their attention span may becoming stretched. They also generally retain large stakes even after the IPO, and these get unloaded in future secondary offerings. This supply overhang could in theory keep the stock price down.

Acting on this theory, I have recently shorted both Burger King (BKC) and J Crew Group (JCG). They have high valuations (P/Es of 45 and 77 though falling), high debt, recent secondary offerings and large stakes still held by private equity firms. I’m near break-even so far. We shall see what happens.

For more info on private equity see:

Special Report of Private Equity (The Economist)
Private Equity Public Offerings (MarketWatch)
This Dog Was Fixed (SD Reader story on Petco)

Risks include a slowdown in reform under the new prime minister Shinzo Abe and possible defeat by the ruling party in summer elections. The Japanese population is aging and this will put strains on a government which is already financially stretched. Interest rates will probably have to rise soon €“ not good for the government, but probably a good sign for an economy where deflation was a big problem until recently.

I do all my Japan investing through closed-end funds and ETFs. I currently hold JEQ and JSC. I recently sold JOF because of the large premium. A list of Japanese ETFs and closed-end funds can be found here. Many mutual fund companies also offer Japan funds.

In Depth
In the late 1980s in looked like it was only a matter of time before Japan overtook the United States as the #1 economy in the world. Japan combined high growth and low inflation and was running huge trade surpluses. Downtown Tokyo was supposedly worth several times the value of all the real estate in the United States, and Japanese investors were buying up American icons such as Rockefeller Center and Pebble Beach. The Japanese economic model, which featured consensus between government and industry, and allowed for long-term planning horizons unattainable by quarterly-profit driven American executives, was widely studied and lauded.

In December of 1989, the Nikkei hit an all-time high of 38,957, having risen from 11,993 at the beginning of 1985. Then things changed. By Sept 1990, the Nikkei had fallen to 26000, and remained in a downtrend until April 2003 when it hit 7824. As it turned out, much of the huge rise in asset prices was fueled by companies using excess cash and borrowing to set up €œspecial financial€? subsidiaries which invested in shares and real estate. More money was wasted paying top dollar for foreign assets, of which Rockefeller Center and Pebble Beach were only two examples. The coziness between business, banks and government meant that bloated companies with connection were kept on life support, while more efficient up and comers were deprived of resources. The result was over 15 years of economic stagnation and mountains of bad debt.

It looks like the stagnation is finally coming to an end. The last 15 years have brought large changes to the Japanese economy including increased labor market flexibility, tougher financial standards, and a breakdown of the cosy relations between companies, banks and government. Foreigners have played a big role, including the turnaround of Nissan by Renault, and a number of takeovers of financial institutions. Signs of change were evident in July 2000, when a plan to rescue Sogo, a venerable and troubled department store chain, was torpedoed by creditor Shinsei Bank, formerly Long-term Credit Bank of Japan and now owned by US-based Ripplewood Holdings. Though the government initially agreed to buy out the Shinsei stake, public, outrage forced it to back down and Sogo went bust.

The political will to increase the pace of reform was displayed with the election of Junichiro Koizumi as prime minister in April 2000. His appointment of Heizo Takenaka as head of the Financial Services Agency did much to end the non-performing loan problem. Koizumi’s reforms included a measure to privatize the Japanese postal system, one of the largest financial institutions in the world.

More Info:

Japan: From Long, Slow Decline to Long, Slow Recovery (Wharton – Mar. 1, 2006)
Walking on Eggshells (The Economist – Dec. 19, 2006)