The concept of private equity is straightforward. You pool millions of dollars pulled from the wallets of wealthy Americans and institutional investors and then make bets on companies you think are underperforming, or growing and simply in need of a little cash to get over the hump from good idea to great business. The rewards can be sensational upon exiting the investment. How this occurs varies, but one common method is through the initial public offering (IPO) where a company offers shares to the public, both newly created ones as well as those of existing shareholders. As an interesting exercise, I thought I would examine a private equity investment from start (initial funding) to finish (IPO), assessing how all the stakeholders made out. (To find out whether this pricey investment is for you, check out Private Equity Opens Up For The Little Investor.)

Changing The Auto Loan Process
The company under our microscope is New York-based DealerTrack Holdings (Nasdaq:TRAK). It got its start in January 2001, when JPMorgan Chase (NYSE:JPM), AmeriCredit (NYSE:ACF) and Wells Fargo (NYSE:WFC), three financial institutions familiar with the manual nature of auto loans at the time, backed the company's push to move dealers online, dramatically improving the efficiency of the lending process. In this instance, the bankers wanted to kill two birds with one stone, making a smart investment while simultaneously improving their auto loan processing. A very wise move in my opinion, and I'm no friend of the banks. The three firms initially contributed $20 million with JPMorgan Partners ultimately investing $26 million for intellectual capital, equipment, etc. For brevity's sake, I'll focus my dissection on JPMorgan's investment, excluding the other founding shareholders.

Follow The Bouncing Ball
Most of the information for this exercise came from DealerTrack SEC filings. In order to calculate the return on investment on DealerTrack, we need to answer two questions: 1) How much did JPMorgan invest? 2) How much did it make selling its shares? Once we have these answers, it's simply a matter of plugging the numbers into a calculator. Presto, we know how JPMorgan investors made out. With the answer to the first question ($26 million) in the previous paragraph, we're already half way there. Now, I'll breakdown the both the accumulation and sale of shares and we're pretty much done.

Pre-IPO
The first step occurred in April 2000, when JPMorgan and Automotive Lease Guide (ALG.com) formed webalg Inc. Each party owned 50%. In February 2001, it received 2 million DealerTrack Series A Preferred shares and 1.25 million DealerTrack Series B Preferred shares. Then in June of that year, JPMorgan received 25 million of webalg's Series A Preferred shares for its 50% interest. At the same time, it bought $1 million in promissory notes paying 8%.

A couple months later in August 2001, DealerTrack and webalg combined. Through the reorganization, JPMorgan ended up with:

  • 624,630 Series B-1 Preferred shares in exchange for its 25 million shares of webalg's Series A Preferred,
  • 2 million Series A Preferred in exchange for 2 million Dealer Track Series A Preferred, and
  • 1.25 million Series B Preferred in exchange for 1.25 million Dealer Track Series B Preferred.

Lastly, JPMorgan purchased an additional $2 million in promissory notes, also paying 8% interest. In December 2001, those promissory notes converted into 801,870 Series C Preferred shares. We are now ready for the IPO.

IPO Breakdown
DealerTrack's first day of trading was Dec. 13, 2005. It sold 10 million shares at $17, with JPMorgan providing 1.61 million of its newly converted common shares. The sale reduced its ownership from 26.6% down to 16.6%, leaving it with 5.61 million shares. Less than a year later, it sold 4.15 million shares in a secondary offering for $23.76 each, reducing its total holdings to 1.46 million shares. The net proceeds of the two offerings were $119.49 million.

Fast forward to the first three months of 2007, and you'll find that JPMorgan was no longer holding DealerTrack. However, because it wasn't a beneficial owner (it had less than 5% ownership), it wasn't required to file a Form 4. Therefore, to approximate the proceeds of its final divestiture, I took the average of the high and low-price for DealerTrack stock in the first quarter ($29.63) and multiplied that by 1.46 million shares which gave me $43.38 million. Add that to the previous $119.49 million and you get a total of $162.87 million.

Bottom Line
JPMorgan and its partners invested $26 million in DealerTrack, generating net profits of $136.87 million over a seven-year period. On an annualized basis, that's a return of 30%. JPMorgan did very well on this deal. On the other hand, the people who took the shares off JPMorgan in both the IPO and secondary offering did much worse. Put another way, those who bought the IPO in 2005 will need annual returns of 86% for the next four years to match results and for those buying the secondary offering they'll need a little less at 72% annually for the next five years. Do I even have to ask who the winner is?

For added insight, read IPO Basics: Introduction and IPO Lock-Ups Stop Insider Selling.

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