In a landscape where private equity firms are strategizing for major exits by 2025, they are faced with a unique challenge: institutional investors are becoming increasingly averse to the debt that often accompanies such transactions. This change in sentiment is prompting these firms to rethink how they can streamline their balance sheets and, in some cases, take on more of the debt for themselves. A suggested strategy involves creative financial engineering that could involve transferring certain liabilities outside of publicly traded entities. This tactic aims to ease the burden of equity required for an initial public offering (IPO), ultimately mitigating the risks associated with high levels of debt.

This approach, although not very common among companies recently listed on European stock exchanges, is gaining traction. According to Alex Watkins, the head of international equity capital markets at JPMorgan, the pressure for private equity to achieve exits is immense. He posits that by offloading some of the debt onto shareholders before going public, these firms can reduce the complexities often associated with IPOs.

Watkins emphasizes that one of the significant hurdles for private equity firms looking to go public is their leverage. Sponsors must decide between pushing ahead with the IPO—potentially necessitating very large transactions—or exploring alternative solutions. The European IPO market, having recently started to show signs of recovery, is expected to see an increase in listings next year, with many resulting from private equity firms that have faced a challenging investment environment. Given that many of these investments were made during an era of cheap money through leveraged buyouts, the rising cost of borrowing is highlighting the pressing issue of debt accumulation.

Recent market observations suggest that firms typically need to keep their debt levels below three times their core earnings in order to enter the public arena successfully. While listing new shares can generate cash for de-leveraging, over-dependence on this method carries its own set of risks. For instance, companies may find themselves facing market pressures that influence their pricing ability starkly.

Bernstorff adds, “A potential solution being considered for next year's IPOs is raising PIK debt at the holding company level while segregating equity down to the soon-to-be-listed entity. This structure would allow sponsors to take responsibility for the debt. Although it bears similarities to margin loans, I believe IPO investors are becoming increasingly accustomed to this type of structure.”

Nevertheless, such solutions bring forth additional risks. Should a company’s dividend payments fall short of covering its debt obligations, private equity shareholders may face pressure post-IPO, potentially necessitating stock sales. Such challenges imply that while companies are weighing these options, their implementation isn't guaranteed.

Financial discipline remains paramount in this conversation. Many firms are actively taking preemptive measures. For instance, last year, Swiss skincare giant Galderma Group AG successfully raised $1 billion through a private financing round with EQT AB ahead of its IPO. This strategic maneuver has proven beneficial, with the company's stock surging approximately 70% since its public debut in March.

Manuel Esteve from UBS, overseeing ECM operations in the region, notes that given the large scale of portfolio companies looking to list in Europe next year, it’s likely that significant IPOs will emerge or that pre-IPO financing strategies like that of Galderma will become prevalent.

For credit investors, the ambitions presented by these IPO endeavors are promising. Raphael Thuin, head of capital markets strategy at Tikehau Capital SCA, states, “Historically, IPOs are viewed favorably by credit investors because they enable companies to acquire additional capital without relying on the debt markets, and in many cases can utilize funds raised to reduce leverage. Moreover, they enhance transparency and financial disclosures.”