Adult finance is quickly becoming the domain of one company. Penthouse Media Group International defined 2007 with its $500 million acquisition of Various Inc., the parent company of AdultFriendFinder. PMGI is at the center of another deal that is likely to shape 2008. The diversified adult media company has announced that it plans to conduct an initial public offering this year, bringing the company back to public capital markets.
The nature of the deal
Only three months after making a $500 million acquisition, PMGI announced plans to sell shares to the public. For the acquisition-hungry company, this is a natural next step, but the details of the proposed filing are surprising.
In typical PMGI fashion, the big news included little more than a statement of the company's intent to make an IPO. The goal is to raise $250 million for the purpose of replacing debt with equity financing. PMGI essentially plans to pay off its loan using the money it raises from the IPO.
Little else has been disclosed. CEO Marc Bell said in December 2007 that he will disclose no more than necessary until "if and when we decide to go public," and he refused to discuss the capitalization of his company at all.
Aside from its public announcement, PMGI has not released any details. In fact, the company did not reply to numerous calls for comment.
PMGI has not indicated how much of the company is being offered to the public, so the company's proposed valuation is not clear. If half of the company will be offered, the anticipated market value would be $500 million until share trading begins. But if Bell is only offering 25 percent of the company's stock, the value of the company on the first day of trading would be around $1 billion.
Of course, these are only estimates, and a variety of factors are used to determine a company's value, particularly for one that is about to enter public capital markets. Without knowing earnings or margins, it is impossible to form a clear view pf PMGI's proposed value. The metrics used to nuance the estimate, such as free cash flow, certainly are not available to the public yet. But this will change if PMGI decides to pull the trigger, since annual 10-K filings (required by the Securities and Exchange Commission) will include the company's financial statements.
Why go public?
The decision to pursue equity capital via an IPO is a bit unusual, particularly given PMGI's ability to raise private equity capital in the past. According to insiders, it is likely that the acquisition of Various was fueled by outside capital, which would imply an ability to bring investors to the table in fairly substantial numbers. In light of the capital needed to acquire various, $250 million seems rather modest.
There are two likely reasons for the decision to go public. They are quite different, making it difficult to ascertain Bell's motivation or determine whether the decision is a good one. One thought is that the nature of PMGI's debt is driving the company to recapitalize, as the company wants to replace high-interest payments with equity that has no ongoing cost associated with it. On the other hand, the decision may be a strategic play positioning PMGI for a secondary offering to be used as an exit strategy for existing equity investors.
While there is no indication that the cost of the debt to be replaced is high, PMGI must be highly leveraged. The numbers suggest it. As announced, the combined entity has an estimated revenue of $340 million. Earlier press releases indicated that Various had $200 million in revenue. As a result, a company with a presumed $140 million in revenue pulled together $500 million to acquire Various. There probably was some debt component to the deal, and the interest rate must have been substantial.
But the debt scenario is not guaranteed. It is entirely possible that PMGI has debt with a low interest rate and simply wants to swap it for equity financing. In this case, there would have to be a strategic reason for an IPO. Among the most popular reasons for a small IPO (e.g., $250 million) is to provide a foundation for a larger secondary offering, which would serve as an exit strategy for the investors.
Francis Koenig, managing director of AdultVest, said he suspects that the existing financing is driving the decision. He is not familiar with the PMGI deal, but in the wake of the acquisition of Various, he believes the company assumed a considerable amount of convertible debt.
With convertible debt, certain circumstances could allow lenders to convert their loans into company ownership (i.e., stock), diluting the shares of current owners. "My experience tells me they're probably trying to remain equity-strong," Koenig said, by refinancing the debt that probably came from the Various deal. Also, given the nature of credit markets over the past few months, Koenig assumed that the debt financing has a high rate of interest. Using an IPO to pay off the debt would result in a lower cost of financing.
There are alternatives to an IPO
The decision to go public is not to be taken lightly. In addition to facing a complex regulatory regime and the obligation to disclose financial information, the act of going public involves a substantial expense, including the engagement of independent auditors, investment bankers and attorneys. All of this factors into the "cost of capital," or how much it costs a company to acquire the money it needs. An IPO, which results in equity capital - the company receives money by selling shares of stock - tends to have a higher cost than debt equity, for which the cost consists primarily of the interest payments.
While it may be prudent to raise capital by selling shares of stock instead of taking on debt, an IPO is not the only solution. Koenig suggests alternative investment vehicles, such as hedge funds and private equity funds, as a possible source of capital, particularly in an economic climate in which most investment institutions are looking for quality investment opportunities.
Private Equity Intelligence Ltd., an alternative investment research firm based in London, estimated that the private equity community alone has $820 billion in "dry powder." These funds have not been committed to a particular investment; this is capital that needs a home. It amounts to more than 40 percent of global private equity assets. There is a lot of money waiting to be invested, and it represents an enormous portion of what the private equity market has at its disposal.
Koenig said the IPO approach is not necessarily a bad idea. It depends on the specific circumstances of the company and the nature of the deal. In general, success is measured by the closing share price on the first day of trading, though serious investors may reserve judgment for many months. But once a company goes public, share price becomes the final answer. An increasing share price translates to satisfied investors. Nobody will know whether the PMGI deal is successful until share trading starts.
This could be a trend
PMGI is likely to be the first IPO, but many more could follow. "A wave of IPOs is coming," Koenig said, adding that legal and confidentiality reasons bar him from explaining further. The success of the PMGI deal is likely to influence the deals that follow significantly.
Koenig said he believes that there is plenty of pent-up demand for adult-company IPOs. "Lots of buyers," he said, "would probably want to participate." Ultimately, though, success will be determined by the terms of the deal - for PMGI and any other adult companies that decide to follow. "I hope it does well," Koenig said of the deal. "I hope this IPO happens, and I think it will."
Koenig said he suspects that the terms of the PMGI deal will play a substantial role in the success of the IPO, particularly in light of the likely substantial debt burden the company seeks to repay. The amount of debt remaining after the IPO will indicate the company's ability to invest in growth. If PMGI has to continue to write large checks for interest payments even after going public, investor dissatisfaction is the likely result. But if the IPO aggressively pays down the existing debt, investors may be thrilled to see a relatively unburdened balance sheet.
The industry will be watching carefully. If PMGI decides to follow through with its planned IPO, it may provide a model for other adult entertainment companies considering taking the plunge.
This article originally appeared in the July 2008 issue of AVN Online magazine. To subscribe, visit AVNMediaNetwork.com/subscriptions.
