Monday, 22 October 2018

IFR US ECM Roundtable 2014: Part 3

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IFR: Ed, you might have the best perspective as a starting point for what the process might be like and how you employ blocks.


LAW, KKR: The topic of blocks is clearly an interesting one, and it’s been interesting to watch the evolution in the US market in recent years in that regard as well.

There are so many areas for debate around that topic. One, is the block trade naturally the right route to monetise your equity through? Sometimes it is, sometimes it isn’t. If you’re seeking to build a long term register of high-quality investors then selling your equity on the basis of the equity story and actually having control as to who that stock ends up with is logically a more appropriate route, and clearly that’s the way the US equity markets functioned for many years.

Having come from, and spent a reasonable amount of time in, Europe as well though, I’ve also seen and worked in a market whereby block trades have become really the default method of monetising equity, and banks have become increasingly aggressive around bidding for stock. I’ve experienced it at KKR as well within the US around some of our portfolio companies where we’ve executed a follow-on. The friction cost of going through the traditional follow-on route is actually pretty high by the time you bake in gross spread plus discount, and the uncertainty as to where the pricing is going to end up.

When you’re looking to sell a block of stock and you’ve been in front of the investment committee and you’ve got authorisation to sell above a certain level and not go below it, then that’s going to be very much in the back of your mind. Not surprising banks are aggressive on use of balance sheet around buying stock off you. It’s an easy choice to make. Coming back to is it the right choice, and the right choice for the long term development of the shareholder register? It kind of depends where you are in the monetisation phase.

So, we kind of give that preamble as a way of thinking about how we approach the process. Generally if we’re going into execution around a block, it’s a pretty straightforward process, as everybody knows. I think to Matt’s point, it’s important clearly to run a process that is an efficient one. There’s clearly nothing worse than requesting banks to bid and then keeping them hanging on the phone for an hour whilst you decide who you’re going to go with, which means they miss that immediate quick-to-market window.

Generally we tend to focus in on not going too wide in terms of the number of banks we call around these opportunities. You’ll focus in on the banks you know are in the flow on the stock, you know have been thinking about it, or are close to the situation. Again, we’ll decide whether we want to go for joint or sole bids dependent, typically, on size of execution. It’s not our choice, but if our portfolio companies are in the middle of buyback programmes, [another consideration is] whether we want to offer them the ability to participate in the trade. That typically creates an interesting dynamic around execution.

But I’d say as a seller when you think about blocks, when you come back to comparing it as a method of execution between a follow-on offering versus an underwritten block trade, the thing that’s extremely hard to prove, and I would love to see some analysis if anybody’s got it, is whether there’s an extra hidden discount in a block trade. In reality I think everyone suspects that there is, but it’s impossible to identify that. What I mean by that is – and John, you should comment – the availability of lock-up expiries, the availability of [information on] who’s sitting on big blocks of stock that are likely to come onto market as people like ourselves are transitioning ownership from private to public, is so widely available that there’s huge speculation as to what blocks are going to come out – not only from banks, but also from investors and particularly from those that play the new issue calendar.

Naturally you can see the performance and trading of a stock can often be impacted into the run-up of a set of results as the market effectively is positioning itself for what is expected to be a block coming out of it. That’s a discount, and that’s a friction cost to sell, but it’s impossible to quantify, which is why I think, coming back to the decision to use blocks, the private equity industry naturally will gravitate towards it, because they’ve got the certainty of execution.


IFR: It seems from what you are saying that a block will always be the best bet to minimise risks.


LAW, KRR: The biggest risk to using a block as a seller is that one of the banks gets the price completely wrong and you end up executing with them, of course they end up left with stock and that can create an impact for the ongoing aftermarket within your company. There are examples out there where you’ve got an additional shareholder who’s a bank, who’s clearly not going to be a long term shareholder in your stock, and that’s a situation, as a seller, you have to be very cognisant of and avoid. Generally I’d say it’s pretty obvious if there is somebody who really stands out from the pack, that the alarm bells should sound as to whether they’re being too aggressive.


IFR: So could the bankers provide some perspective in terms of your approach to blocks and how you think of it as a business?


REECE, CREDIT SUISSE: Ed was very eloquent in describing the process; the way I think of it is he’s holding a velvet hammer, and I’m frequently getting hit with it. The risk is completely asymmetric in some regards; say it’s a half billion dollar block, when we transact we own it, right? They may or may not own additional stock, but if that half a billion dollar position goes down 5%, and we bid it down 1%, they’re not feeling the pain unless they are back in the market immediately. So there is not symmetry of risk whatsoever; from a sponsor’s perspective it’s a very attractive proposition, why wouldn’t you take it? But for us if we get it wrong, it can be very, very expensive.

We do view it as a critical part of the business – we have to. For a sponsor issuer seven or eight years ago, you would do an IPO, you do one or two marketed follow-ons, you might do an accelerated deal, and then you sort of get to block land.

Now you do an IPO, you might do a marketed deal, and it’s done. It’s one and done, boom, start blocking it, because in the current environment of relatively low volatility and buy-side accounts looking to increase equity exposure in size, pricing on blocks for sponsors is very attractive. However, I would add that pricing discipline and risk practices for the underwriters remains critical to managing this business successfully.

We did four blocks last week, and a range of block bids, we did one down 50 basis points, and the widest was 5 points. I don’t know if you guys have a different view of this…


MORIARTY, BofA MERRILL: I think you have to assess two things. One, what’s the situation? Is it secondary stock coming out of KKR, or is it primary issuance for REITs? We went through a period in 2008 where all the REITs were scared to take any market risk. Well, fast forward to the beginning of 2009, and market risk became market opportunity, and actually marketing deals made sense, because there was scarcity, and the market was trending up. So that sector really benefitted from marketing.

I think you have to look at the shareholder depth. It’s interesting, Ed mentions the bad outcome is if the bank gets hung with the stock: Totally fair. The other bad outcome is if you crystallise a discount that doesn’t need to be there.

Now, we’re in a market environment with low volatility, and actually declining secondary volume. So, for the buy-side, the liquidity that we’re providing for them in the form of blocks is actually a [positive] attribute, right? The beneficiary of that is the secondary seller, in the form of the private equity firm, so that explains these very, very tight discounts. I think it’s reflective of the situation and the market environment we’re in.

We’ll go through another cycle and volatility will be higher, those discounts will get wider and you’ll assess the relative situation. Does it make sense to market? Is it market opportunity as opposed to market risk?


DRURY, CITIGROUP: JD makes a number of good points. We don’t necessarily view this as secular. I think we view it as cyclical. Risk is down 18% from a dollar proceeds point of view. It doesn’t feel like it, but risk is down quite meaningfully on last year, and IPOs are up 20%.

JD’s points are right. Everything is situation specific. Most block trades are secondary, unless they’re in real estate. So there’s not necessarily a story to be told on why the capital raise is occurring. Most block trades focus around 10 days of volume, 10% of outstanding. They’re seasoned companies, they’re liquid companies. They have diversified shareholder registers.

So that means they’re well known, and I think the point was made by Ed, which is that a number of investors assume the cadence of monetisation of sponsors. The blackout periods around earnings are quite punitive and they own some very large positions.

We started to see increased IPOs in 2011 and the block trades that we saw in 2013 and we’re seeing in 2014 are the final monetisation strands of those LBOs.

Interestingly, if you look at the largest 25 LBOs that have taken place pre-crisis approximately 50% of them now have been fully monetised by the sponsors. Yet, we talk about the IPO market today being up 20%, so the way we look at the block trade market [is] we’re at a very, very seasoned cyclical point in the block market. Our belief is when we get into 2015 we’re going to be starting to hit first follow-ons again [and] they shouldn’t be on risk. Then I think we’ll see a pick-up in block activity in 2016 and 2017.

Now, all of that is obviously going to be dependent on market conditions. When you’re in a market, as JD said, which is very low vol, which grinds higher, you’re probably going to be right, even if you’re marginally wrong on the price, because with the S&P 500 grinding higher, you have a tailwind behind you.

Our own strategist sees little upside between now and year end, and 5.5% upside in the S&P 500 between now and the year end of 2015. You may well see a more cautionary stance from the underwriters.


SPERLING, ROTHSCHILD: The one thing I was going to add, Phil, to your point at the end is, it’s not simply, “Oh, take five big banks, or three big banks, or seven, or the three last bookrunners” And bid out every block the same way. There’s actually – and I think to the broader world this is less well understood, at least as we’ve seen it, and we’ve seen all the participants –a lot more differentiation in outcomes than one would think, and it’s not simply the three desks up here, or whatever, or four desks, chugging out the model and saying, “Aha,” and everyone is grouped within 10 cents and then you pick the top two and join them to buy the block.

It’s more sophisticated in the sense that for every situation you’re either expecting a certain outcome, and then the bank that maybe has an edge on trading and an edge on research or an edge on whatever, gets the call right. Or God forbid gets the call wildly wrong, which is not good for anyone, and no one wants that to happen.

I’ve been in enough situations – I mean, one recent example we ran involving the firms here was Sealed Air, which was the only block trade ever under US$500m where a bank bought it at last sale. CS called it right, and re-offered above the last sale and got it done terrifically.

Or BAML buying a billion dollars of risk in General Motors from the Canadian Government. Now, everyone on the Street was trying to position for that trade, no one knows when Canada’s going to sell. Obviously at some point Canada is going to sell, and is going to sell at some point again, sure, but amongst those banks bidding, getting the call right, there is plenty of differentiation in those outcomes. Who’s got risk on in a certain way, and who believes their analyst knows where the bodies are buried, or has an edge on the sales and trading side.


IFR: Does anybody from the audience have a question?


AUDIENCE QUESTION: Along with the rise of the IPO market, it has been a record year last year for sponsor-backed IPOs. What is the current appetite from the buyside for these sponsor-backed, leveraged IPOs?


ROSS, BLACKROCK: It’s a hard question to answer, because it’s just so idiosyncratic. Certainly the way we look at it, it’s not dissimilar I’m sure to the way you guys think about a business. When you’re pitching and looking at the leverage, is, what does the run-rate deleverage profile look like? What do we think of their free cash flow generation? What does the free cash flow profile look like? If all of that seems reasonable, a near term uptake in leverage is not something that particularly troubles us.

We understand what the sponsor’s objectives are with owning these businesses, so there isn’t some sort of a naive expectation on our part that there is going to be a sponsor company where the company is one-time leveraged or that sort of a dynamic.

It does come back to the business itself. But we’ve been participants in some of the sponsor IPOs. It’s hard to say from a general standpoint, “Yes, no. Good, bad.”


DRURY, CITIGROUP: You look at the size of these LBOs, and you look at the equity ownership of sponsors, the fact is that the IPO is typically 15%–25% of the equity value of the company. In theory, the IPO is the lowest price where the sponsor will ever sell. They’re absolutely aligned with investors to make sure that the IPO gets off well, and that they establish a diversified shareholder base.

A huge attraction for the IPO is the alignment that the sponsors have with investors moving forward.


LAW, KKR: I guess I’d say, Phil, as well, the realities as a sponsor, your business model is, “We have to sell our best assets”, whereas if you’re on the buyside you’ll actually buy and hold the best assets. So, naturally, given that we operate funds that have specific lifetimes etcetera, we will always have to bring our best assets to the market, and to Phil’s point, we’ll also be the biggest shareholder in the aftermarket. So it’s critical for us that the IPO is just the start of the process, it’s not the end.


ROSS, BLACKROCK: One of the benefits we have at BlackRock is by having large fixed income portfolios as well, quite often we are already very familiar with these companies, because we’ve already been investors with them, along with the sponsors, for as long as you’ve owned them.

So, one of the things we focus on an awful lot is trying to translate that knowledge across the platform. We try as best we can to transfer that across the organisation, to get the equity teams up to speed that much faster.


REECE, CREDIT SUISSE: Well, all things being equal, on company quality, if you don’t play the sponsor calendar, the calendar is going to be markedly smaller. I think last year’s sponsor equity issuance was about 40% of the calendar in the US. If you’ve got an aversion to that if you’re on the buyside that leaves a markedly smaller choice of investment opportunities.


MORIARTY, BofA MERRILL: It’s kind of a funny way of thinking about it. The marginal investor will look at a series of sponsor IPOs, for instance, that work well, and they’ll be more interested because they’ve worked. Similarly, when they don’t work well. So for instance, we’ve seen greater tolerance of leverage. Iif you were to ask us two years ago about a break line on leverage, at the IPO, we’d probably tell you four, four and a quarter [times Ebitda]. Then you’ve seen things like HD Supply, you’ve seen things like Intelsat, you’ve seen Realogy – a phenomenal example – where the equity story is good enough and people looked right through the leverage.

When the marginal investor starts seeing that and says, “Hey, these sponsor deals are working”, then that matters, but I think for big institutions like yours, you don’t start with it being a sponsor IPO.


ROSS, BLACKROCK: When I used to be sellside, you’d sometimes hear chatter about different sponsors. “Oh, I’ve heard chatter from the buyside that they’re never going to buy sponsor X’s deals again.” I’ve actually never heard one of our investors comment on a particular sponsor, again because it comes back to the point that it’s all idiosyncratic risk exposure. Based on our valuation of the business, [the question is] does it make sense or does it not at a particular valuation? That, at the end of the day, is the fundamental [thing].


MORIARTY, BofA MERRILL: The pendulum swings. When the market is talking about, “How will the rest of the market treat this”, that’s not investing for most of your PMs.

The second you say ‘overhang’ you’re defining your hold period. To a certain extent you’re saying, “Yes, this isn’t going to get marked appropriately by everybody else, so I’m not interested,” right?


AUDIENCE QUESTION: Testing the waters. We’ve heard a lot about testing the waters in the biotech space, and some of the other healthcare companies; could you talk about whether you’re seeing it in other sectors, and generally what your view is on testing the waters?


DRURY, CITIGROUP: We think pre-market education is something that in the right circumstances will add value: Complicated stories, unfamiliar management teams.


ROSS, BLACKROCK: From our perspective, because obviously we get calls on these sorts of situations quite frequently – I sort of agree. Talk is cheap, so when people want to come through, they don’t have a deal, management sits down and then they ask us, “What do you think the right valuation is?” The value to us of those meetings is familiarity. If you’re looking to create a dynamic where you’re trying to maximise, for example, at BlackRock, the number of folks who are going to be interested, with a three-to-five year time frame, that comes with familiarity. So for us, the value is getting to meet management, getting to hear the story and then just sort of percolate on it for a little bit. That way when the IPO eventually does launch, and we meet management again – I always say it’s good to say, “Nice to meet you again,” versus, “Nice to meet you” – we already have some familiarity as well, we probably have already done some work, that’s really the value for us.


LAW, KKR: I think from an issuer’s perspective, picking up on Jonathan’s point, we’re big believers in, call it what you like, testing the waters or early stage meetings, basically for the purpose of building that relationship between management and some of the thought leading investors that are out there in the sector.

That’s something that we see as very valuable. If I was to turn to my private equity colleagues and say, “Okay, we’ve got this business, you’ve got 40 minutes to spend with management and then we’re expecting you to put in an order in three days to buy the business”, they would look at me like I’d arrived from a different planet. That’s kind of what the traditional IPO process is, and what you’re asking investors to do, so I think there’s huge benefit in doing it.

Like anything, there can be companies where it is more relevant versus others: If there is very clearly defined sector benchmarks, people already know and understand the business because maybe it was either previously public or it’s relative to the competitive performance of the other companies. It could be less relevant, but generally I think it can be very valuable.


SPERLING, ROTHSCHILD: There’s also still differentiation among the banks, and even within the banks, among the individuals on the desks, amongst sectors, who’s more likely or more inclined, or pushes back against it. It’s complicated.


MORIARTY, BofA MERRILL: Interestingly, the primary sectors that are doing it, aside from healthcare, are technology and probably consumer and retail, more growth-oriented businesses where the comparables are few and far between. So understanding the business is somewhat challenging and is an educational opportunity for both the buyside and for the company. So what we’re trying to do is encourage the company to approach it the right way. Don’t go into this thinking that you’re going to get a bunch of orders. Don’t go into this thinking that this is about finding out exactly what you’re worth, and, by the way, don’t go into this and expect the investor to send you back tons of feedback either. Go into this so that you make relationships, as you say. If you think about it as a continuum, right, I think Ed points out the IPO process with 45 minute meetings, hour long meetings and quick response is on one end, a private placement would be on the other. If you think about what I identified as one of the goals before, which is concentrated dedicated holders, this helps you get there.

Now, there aren’t many things that I thank Congress for. This got rushed through very quickly. One of the laughable things about the JOBS Act is when it came through, if you look back at the previous 12 months, the US$1 billion in sales standard would have applied to 93% of the supposed emerging growth companies. So they’re effectively biasing against 7% of the outcomes, which doesn’t make a whole lot of sense. There are some silly things that have occurred here. It’s evolved. The buyside has, I think, adjusted.

So, for instance, we see much more receptivity in New York and Boston than we do in San Francisco on this, in terms of people interested in the value of those meetings, but I think by far the best thing [about testing the waters] is getting an understanding of businesses, and so we’re selective as to which businesses we send out doing it.

One of the risks is that sometimes the buyside can be very polite to management teams, and so we have to kind of say: “Just recognise, before you go into these meetings, they’re going to be polite, they’re not really going to criticise you necessarily, they’re going to take in information, and that’s fine.”

That’s what they should be doing. We want them to get familiar with you. A lot of management teams want to do tons of these meetings, because they feel very, very good when there’s not an outcome associated with it, and it’s just “Hey, you have an interesting business.”


APTHORPE, RBC: It’s not directly related to the IPO market, but it’s interesting because we rely on testing the waters or pre-market sounding aspects within the equity-linked sector. Oftentimes it allows us to redefine how we think about the risk, and this dovetails back to bought deals and banks’ appetites for bought deals. We’ll use this ‘market sounding’ over the course of two days leading up to a transaction, and routinely that leads to an overnight transaction for a company. If you think about ultimately why companies are trying to do overnight bought deals it’s to avoid the market risk, or sponsors looking to exit, because they’re looking to avoid the market risk.

The problem with that oftentimes from the company’s perspective is that it leads to hedge fund placement, which isn’t necessarily in the company’s long-term interests. So if you think about testing the waters, a pre-market sounding over the course of a couple of days can lead to a transaction that can be accelerated to an overnight deal.

We’ve led our last six deals on an overnight basis without a technical back stop or bought deal aspect to them, without the company having to pay the market concession for that insulation of risks. So the technology is valuable, not only in the IPO context, but also as you think across the spectrum to the equity-linked field.


IFR: Let’s wrap it up there. Thank you everyone for coming to the roundtable, and thank you to all the members of the panel. I think it was a fascinating discussion. 

To continue reading this roundtable, click the relevant section. Introduction - Participants - Part 1 - Part 2 - Part 3

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