IFR US ECM Roundtable 2015: Part 1
IFR: accommodative monetary policies have sustained a cyclical bull market across the capital markets. Stocks have nearly tripled from post-crisis lows even after factoring in the recent sell offs. Merger and acquisition activity is at historic highs and private companies have enjoyed unprecedented access to capital.
Yet there are plenty of reasons for pause. Economic conditions globally are frail despite the ongoing recovery of the US. The reality of higher interest rates threatens to choke access to capital and is already manifesting across the energy and commodities complexes (the roundtable was held just a few days before the US Federal Reserve opted not to increase rates).
Stock market volatility as measured by the VIX is elevated above 20, historically a no go for equity capital markets.
Yet we are told that companies and financial sponsors may be called to action by volatility. Albertsons, First Data and Neiman Marcus, some of the largest buyouts in recent history are queued up to go public as are SoulCycle, Pure Storage and a more esoteric list of biotechnology companies.
Brett, equity market volatility has picked up recently. What factors are driving volatility broadly in the markets?
Brett Paschke, William Blair: The factors are pretty well known. It’s the central banks across the globe, the slowdown in China, the focus on the US’s underlying economy and is it ready to take the baton from the Fed.
ECM people are generally optimistic people. You sort of have to be, and when we go through a period like we went through I try to step back and bring some broader context. One interesting statistic is that in 85 of the last 100 years there’s been a correction of 10% or more. We got a little spoiled here over the last two or three years because just month after month was straight lines, straight ahead, low volatility. People got surprised.
ETFs and the impact of high frequency trades have contributed to volatility. But we are right at the S&P 500’s all-time average right now on price/earnings multiple. We got our 10% correction which is making a lot of people feel like it is a buying opportunity.
From a capital markets perspective, the uptick in volatility happened at the best possible time it could have happened, which was a very quiet deal market. So there wasn’t a lot of deal disruption or deals that priced and then performed terribly or priced really poorly relative to the ranges.
If things moderate from here, it could be a pretty painless and probably constructive correction.
Craig DeDomenico, Stifel: In talking to our sponsor partners, investing PMs andcorporate management teams, clearly our clients are in a mode of hurry up and wait as being prepared to move quickly is even more critical in volatile markets. I think everybody wants to be at the front end of this issuance window when it returns but they don’t want to be first. I think obviously we have a role to not send issuers out into a market when one of every two days seems to be plus or minus 300 on the Dow.
Obviously the viewpoints on economic conditions later this week from the FOMC meeting will be an important driver of markets, but if they don’t move on rates their impact won’t go away, whether it’s October or December. Obviously from our perspective, I think an important new issue driver will be closing out the third quarter. This year, capital markets bankers already had a difficult September to manage given the late holiday schedule so given that coupled with market backdrop we’re asking issuers to close out their third quarter earnings results and importantly being patient as investors close out the quarter. Everybody knows it was a very difficult third quarter for fund performance which impacts investor psychology and willingness to spend new dollars.
All that said, we are selectively launching deals post Labor Day but most of those were case specific – healthcare with some crossover funding and a few that were more related to M&A funding. Again most of our backlog will come after the 9/30 timeframe.
IFR: Frank, what are your expectations for the market environment after the FOMC decision this week and what sort of advice are you giving clients on how they should act, whether they should proceed with deals in the next little while?
Frank Maturo, UBS: There are a lot of conversations going on right now on valuation, and how valuations have changed from early mid-summer until now given the increased volatility. The big question mark is does that volatility increase from what we’ve seen in the mid-teens up to the mid-20s? It was the high 20s but has come down recently. Has that changed the IPO discount and has that IPO discount changed companies’ value expectations?
The question is how much activity is there going to be. A lot is going to depend on what the VIX does post Fed. Again I do think it’s been well telegraphed that the Fed could increase interest rates by 25 basis points. The more important thing is what message the Fed gives for the future outlook over the next few FOMC meetings into the end of the year and beginning of next year. That is what the market is going to react to.
IFR: Can you give us insight into the valuation discussion and what the discount might be to the public comparable as compared to what it might have been earlier in the year?
Frank Maturo, UBS: The IPO discount that most people use is 10% to 15%, sometimes when we’re pitching business it’s 12.5%, the midpoint. Other times its 15%, depending on the growth of the company and the leverage. Now there is some discussion on should we be using a higher IPO discount or a 20% IPO discount. Right now everyone would like to stay in a normalised IPO environment which would say 15% IPO discount.
IFR: Jim, do you have any thoughts on that?
Jim Cooney, BAML: I deal with a sector that tends to be a little bit more in risk orientation. We have two IPOs on the road right now that have normalised IPO discounts of about 15%. Both of those deals had very strong crossover interest going into the launch. So that’s probably not a great barometer for what Frank is suggesting is a wider IPO discount.
What we believe that in these markets the lower end of the range needs to have a hook and sometimes that hook is about 20%. So we try to orient our clients thinking and have been trying to orient our clients’ thinking over the last couple of weeks that maybe it’s 20% IPO discount at the bottom end, a 15% IPO discount at the midpoint and a 10% discount at the top end.
IFR: Has that changed significantly?
Jim Cooney, BAML: It has changed significantly. We all love to operate in a low volatility, less-than-25-type environment. We’re at 25 right now and I think you would normally have seen a May/June/July IPO looking at about 15% or 10% IPO discount. That certainly has gapped out here in the last couple of weeks.
IFR: Matt, there’s been a lot of disappointment around IPOs in the last maybe year or so. People are maybe a little bit confused as to how IPOs in many cases seem to be very heavily oversubscribed and then they haven’t always traded well. There’s a large proportion of IPOs that are trading below issue and in some cases on the first day. Can you give some insight from your perspective on how that happens and how to balance off the expectations of issuers and investors?
Matt Sperling, Rothschild: You get data points from investors and that’s where the science and the arts converge into the black arts that everyone in this room and on the panel are involved in.
Quite frankly it’s tough. I mean it’s not an easy process in the first instance because one hopes one’s getting clarity from investors and getting an often fairly detailed picture. Folks might on that side be talking their own book and trying to pitch as to where they’d like to see valuations go and where they’d like to be in terms of an order and size.
The degree to which one can create transparency both for the issuer and the owners who are making decisions to get a meeting of the minds between sellers and buyers over the past year has probably been more complicated than historically.
That’s partly due to rising volatility and in part due to the reasonable degree to which momentum-type investors come into these transactions, particularly if they think a transaction is going well.
A lot of times, it’s the job of folks on the table up here to sort of tamp down expectations and to try, if anything, to keep the market in check such that the momentum doesn’t take hold of itself. When it does you get these self-fulfilling prophecies of the sort that you’re talking about where you sometimes see deals get massively oversubscribed with what appears to be very little valuation sensitivity on the part of investors.
Once you look at that book in detail, there’s a quite large amount of it which is fluff and there’s a fair amount of it which is real. Finding and putting something together that will work for the seller and hopefully attract the right types of buyers who are going to be partners and are going to be in the aftermarket can be complicated.
I won’t point to any specific transaction. Where you can get into a little bit of trouble is where there appears to be a lot of leverage that the seller had with maybe not as much transparency as one might have thought in terms of where the fundamental support was, both for the transaction and in the aftermarket.
When you do things like move the range, increase the size and various things like that, you’re signalling to the aftermarket what your expectations are for that transaction and how it will trade and where the demand is. Sometimes when that demand doesn’t materialise in the first split second, you find out pretty quickly that the investor base perhaps wasn’t there.
Obviously everyone spends a lot of time trying to ensure that that’s not likely to be the case. I think that probably means a fair amount of caution certainly through the rest of the year on this exact kind of issue.
Tom Morrison, Blackstone: One thing that’s added to the complexity is that it’s generally a flat equity market and because of that investors are looking for performance. It’s not easy to find it. There’s not a ton of growth given what’s going on in the economy and with earnings growth. So if you can get performance in an IPO – the average IPO I think is up like 18% on day one this year – you’re getting books that can become quite heavily subscribed. It’s the challenge of the capital markets teams and the syndicate desks to really separate who wants to own a stock from who’s there to rent the stock.
We’ve all been through markets that get frothy and then you see a deal price at the top of the range or a dollar above and then trade down. You say: “Wow we’re at a place where you have to be super careful.”
IFR: Rob, if we could transition to energy a little bit. With low $40 oil prices, a lot of people are wondering where we might go from here? And as we look towards fall redeterminations to the reserve-based credit facilities, how much stress will that impose on the industry?
Robert Santangelo, Credit Suisse: There’s likely to be modest near term stress. The stress builds through multiple redeterminations over time. The equity and debt markets were wide open in the first half of the year for energy companies. The overwhelming percentage of companies have termed out most of their reserve-based lending. So in most cases the revolver is largely a liquidity cushion. People are going to see that liquidity cushion shrinking, but it’s not going to create an immediate financing need in many cases.
In the cases where it does create that need, and there will be some, they’ll tend to be maybe the smaller or the less well positioned companies. However, I don’t think it’s going to affect the majority of the market cap in the group.
IFR: Are there alternative sources of liquidity for some of the companies? There’s been some uptake in M&A activity.
Robert Santangelo, Credit Suisse: There are the haves and the have-nots. In the case of some of the have-nots, it’s going to be secured lending and mezzanine financing on tough terms if they can get it. Then for the rest of the companies, although the markets are not where they were before, they are generally open and accessible to the better positioned companies.
IFR: Tom, it seems like this might be an ideal time for private equity.
Tom Morrison, Blackstone: Obviously with prices in the commodity decks coming down, that creates some dislocation for companies, as Rob said. Some of those companies can finance in the public debt and equity markets and some can’t.
We have raised a fund to invest in energy assets. We also invest in energy assets out of our general global fund. So we have had a lot of dialogue with energy companies along the way, including how we might be able to work with them and bring capital and operating resources to bear.
This is an environment where there may be opportunity for us. We’re excited about that.
IFR: Rob, thinking about MLPs and yieldcos, these are vehicles that need access to capital. There have been times in the past when there is no access to capital. Is that what’s going on right now with some of the MLPs?
Robert Santangelo, Credit Suisse: Clearly the MLP market is strained right now in terms of availability of capital against what people would like to finance. The market has had a 50% reduction in financing on the equity side this year and that probably totals up to a US$7bn–$10bn deficit in terms of what people would have done versus what they’ve done. That builds over time and becomes something that at some point people need to act on.
The equity markets are open for the best issuers in the MLP space. They’re closed for quite a few. There are a lot of private capital buyers who are investors in public securities that want to put money into these companies. However, the companies don’t yet feel that it’s in their interest to do that.
As we push on to the end of the year and into next year, we’ll have to start to see some financing activity or some asset sales or other activities as time presses on.
IFR: Is that stress within MLPs directly tied to lower commodity prices?
Robert Santangelo, Credit Suisse: It’s indirectly tied. Clearly the growth prospects of the MLPs have moderated with the reduction in upstream spending and upstream growth. However, a good part of what we are seeing in the market is technical.
In the MLP market specifically there’s a very high percentage of dedicated MLP investors. Funds flows follow performance. Performance of MLPs versus the broad indexes has been quite negative for three consecutive quarters. As a result of that you have a funds flow technical issue that I think is as important, if not more important, than the impact in the fundamentals.
Most investors we speak to, if they’re dedicated investors or people who are looking to put money to work, find MLP valuations attractive at current levels. That’s very encouraging for the outlook.
IFR: Earlier in the year at the time of some of the early capital raises for E&P companies, your firm’s call was for a mid-US$70s mid-cycle oil price. We’re seeing the low US$40s now. Is this a contagion spreading to MLPs, yieldcos and other investments?
Robert Santangelo, Credit Suisse: There’s clearly been a reduction in the mid-cycle oil view. I call it a lower for longer mindset. That has probably moved people from expecting a US$70-ish mid-cycle number to something in the US$60s. That has a meaningful impact on valuations as you run through it.
Some of the technical issues we’re seeing in the yieldco space have shifted across from the MLP market. All of this ties back into the reduction in long-dated commodity expectations for oil from US$90 let’s say to in the US$60s.
Talking to investors, most of what you’re going to see in the good stocks has already happened. Most people we see have a constructive mid- to long-term outlook on the group right now, both on the MLP side and on the upstream side.
IFR: Can you put into some perspective what’s going on with yieldcos? We saw NextEra Energy use higher leverage, lower equity funding to fund a recent dropdown to its yieldco, NextEra Energy Partners. We’ve seen SunEdison look to offer alternative forms of capital in response to its low share prices at both the parent and yieldco subsidiaries.
Robert Santangelo, Credit Suisse: The yieldco market has had obviously a pull back. These were very popular securities and as a result of that they all extended past where their valuation should be. That’s clearly been the contributing factor across the yield space. The prospect of rate hikes has certainly impacted the group.
The yieldco space has also been impacted by a spill-over from MLP investors. There’s a decent overlap in the investor base. People have questioned their ability to maintain growth through equity issuance.
What you’ve seen in those two cases are parent support in effect of taking some of the funding pressure out of the market on a short- to medium-term basis to fund announced acquisitions. It still raises the question ultimately over time for these things to grow they’ll need access to the markets to do future acquisitions.
Not to be a Pollyanna, but we have quite a constructive outlook on the yieldco space as well. The demand for yield products even in the face of slightly higher real interest rates is going to continue. Over time there’ll likely be less issuance out of the MLP space because there’s less organic growth and that yield appetite will find its way into long-term contracted assets in the yieldco market. We think the winners in the yieldco market will consolidate and have a good run forward after we get through this period.
IFR: Transitioning to healthcare Jim, what types of biotech companies are attracting capital. It would be helpful if you could provide a breakdown.
Jim Cooney, BAML: Maybe I’ll touch on the broader performance of healthcare and the reasons healthcare is performing so well. It clearly is a question that we tend to get multiple times a day and then the other question is: How long will it last? Rob touched on fundamentals and technicals and both things are frankly at play in the healthcare market.
From a fundamental perspective many investors, drug discovery experts, companies, boards, venture capitalists would argue that we’re in a golden age of innovation. So you’re starting to see company valuations reflect new drugs coming to market. There are new subsets of markets being established and that’s really what’s driving a lot of the IPO business we focus on.
Immuno-oncology is certainly one area that’s very hot. If you look at 2015 there have been five companies that have gone public in immuno-oncology with pre-money valuations of a billion dollars or more. Prior to this year there was only ever three companies in biotech that have gone public with pre-money valuations greater than $1bn and one of them was in immuno-oncology. That’s certainly one hot market.
Gene therapy is another market that’s certainly gotten a lot of attention over the last couple of years. That would be another subset.
Then obviously orphan disease (drug development) is the third area that investors are looking at.
The FDA approved 44 drugs last year – that’s the highest in 18 years. So we have a more cooperative regulatory backdrop. Based on the run rate this year, we’re on track for about 35 or 36 drugs to get FDA approval. Companies are discovering better drugs, taking them to the FDA, getting approved and getting approved faster.
Number three is M&A. That’s providing a nice bid for some of the small cap issuance. We’ve seen M&A activity that’s been extremely constructive the last few years.
If you look at performance and funds flows, the healthcare market has outperformed the broader market for five years in a row. Not surprisingly the last four years have had positive funds flows. That compares to the six prior years having negative funds flows when ObamaCare, the Affordable Care Act, were enacted. People didn’t know how to value healthcare companies so they stayed underweight when the transition happened.
In addition, the disruption in the market is primarily driven by international forces whether it be Greece, China or the emerging markets. Whatever it is, you want to stay away from those stocks exposed to those issues. There are two good industries that are not correlated. One is consumer non-discretionary, the other is US healthcare.
Lastly from a new issuance perspective, which is why we’re all here, four of the five best-performing IPOs one-day performance this year are in healthcare.