Playbook-A Case for A Welsh IPO (Someday)-November 2011
It was a little over a year ago that Welsh Property Trust took two runs at a $350 million initial public offering before finally pulling the deal. CEO Scott Frederiksen says he has spent virtually no time planning another attempt at a public offering, and during two separate conversations recently, he observed that the Dow Jones Industrial Average was down triple digits again. In looking back at the extensive effort to go public in 2010, he says, “at least we did not miss the window by a week, or something like that. The market for IPOs was crappy then, and it’s crappy now.”
He’s right about that. We are supposed to be in the middle of a boom for public real estate investment trusts, or REITs. “Everybody wants to be a REIT,” according to a column in the Pensions & Investments newspaper earlier this year. Real estate values are down, and opportunities to buy abound. And investors in recent years have relearned the value of liquidity. A public REIT is considered the best way to buy a portfolio of rental property and still keep your investments liquid.
Heading into autumn, the anticipated 2011 boom in REIT IPOs hasn’t happened. There were nine initial public offerings of REITs in 2010, and the most recent data from the National Association of Real Estate Investment Trusts shows eight thus far in 2011. That’s compared with 29 in the peak year of 2004. What has been working is the market for secondary offerings in REITs—78 of them through August 31, raising billions. Capital is flowing into real estate, and it’s going to the proven public players. It’s enough to make me all but certain that Welsh will try the IPO route again.
Prior to the IPOs, Welsh had tried private capital. It’d raised money through broker dealers. As Frederiksen points out, there is a “cost of capital,” driven by return expectations of investors, and then there’s the “cost of raising capital.” He says that in some of those previous private capital efforts, by the time a dollar was invested in a building, maybe 10 cents or more was gone for fees, commissions, and other costs.
If you looked at Welsh’s filings from last year, you’d have a hard time seeing going public as a cost-effective strategy. Welsh had to first form a business structure that could be taken public. At the time of the IPO effort, its portfolio consisted of 57 industrial and eight office properties. So imagine this deal as the simultaneous merger of 65 companies and an initial public offering. Roll in Welsh’s service businesses as well, and total fees and expenses associated with the REIT came to $13.54 million, according to Welsh’s final amendment to its registration statement. This was cash out of pocket, not commissions that did not get paid. There were approximately 15,000 hours of accounting time for audits and purchase accounting for all of the LLCs and partnerships—some of them existing since the 1970s. Boulay Heutmaker Zibell & Company, Baker Tilly Virchow Krause, and KPMG split $8.4 million in fees.
The Welsh leadership team knew the IPO’s financial hurdles, but looked to the REIT as a path to long-term growth equity that would dwarf all previous efforts. And they were thinking big. According to its filings, Welsh had 9.6 million square feet identified and ready to be acquired. It also planned to use about $50 million of the IPO proceeds to retire debt on the existing portfolio.
In May 2010, Welsh initiated its public offering, proposing to sell 17.5 million shares at $19 to $21 per share, for a total raise in excess of $350 million. John Guinee, a leading REIT equity analyst for Stifel Nicolaus & Company, says the market environment was weak, and Welsh quickly received investor push back on valuation. Welsh subsequently resized the deal in late June, dropping the valuation range to $16 to $16.50 per share, and increasing the shares offered to enable the deal to net about the same amount of capital.
“They got some very bad advice from their investment bankers, who shall remain nameless,” Guinee says. (UBS Investment Bank was lead banker.) “By the time they saw the light and adjusted their pricing, the public market had sort of moved on.”
So no public deal, hundreds of hours of executive and staff time up in smoke, and invoices for accounting and legal services piled to the ceiling. Worse, no money with which to acquire 9.6 million square feet of real estate.
Frederiksen says, however, that the team had more or less simultaneously been working on a private equity deal. They had talked to several firms even before filing for an IPO, and had formed a relationship with Rothschild Realty Managers, LLC, a New York private equity fund sponsor that had just raised its fifth fund. Frederiksen was in regular contact with Rothschild, even once phoning an update from his IPO road show. When the IPO was shelved, talks picked up.
Having done all of the auditing and diligence for the IPO made getting to a deal with Rothschild easier. Late last year, the firm announced a commitment to Welsh of up to $200 million from Rothschild’s new fund.
Frederiksen declines to be specific on Rothschild’s return expectations, but suggests Welsh’s strategy of buying leased, well-located industrial assets that are conservatively leveraged will provide returns. With this approach, my guess is that Rothschild is looking for an 11 percent to 13 percent annual cash return.
But that level of return— compared to what a REIT would have provided—makes the financing more expensive. (Because a REIT offers investors liquidity, its return expectations would range from 7 percent to 9 percent.)
If anything, a public REIT is a better idea today than it was two years ago. In addition to the hundreds of investors Welsh has in its funds, partnerships, and other deals who could use the liquidity offered by a public market, Welsh now has a private equity partner that will demand its money back some day.
“Yeah, but we have never raised money with the promise of liquidity,” Frederiksen says. In Welsh’s IPO effort, “we almost gave [investors] something that they did not expect.”
Welsh has deployed a little more than half of the capital Rothschild committed to the company; Rothschild is a long way from needing an exit. Eventually rolling Rothschild’s equity in Welsh into a new Welsh REIT is just one option, Frederiksen says.
“A lot would have to change” in the market, he adds, “before we would try that again.”
Lee Schafer (firstname.lastname@example.org) is managing director of Minneapolis-based Sargent Advisors, which guides clients on growth strategy, mergers and acquisitions, and licensing and joint venture opportunities.