IFR US ECM Roundtable 2015: Part 2

IFR: Interestingly tech as a sector has taken a backseat to healthcare and some other sectors and there hasn’t been that many tech IPOs recently. When there has been some, we’ve seen some down rounds or situations where the public valuation of these companies has been lower than the most recent private funding round.

At the same time we’ve seen very large private funding rounds by some of the so-called unicorns, such as Uber and the like.

How do you see this disconnect between private and public valuations resolving itself? Do you think all these companies will go public one day or will they stay private or will there be some other resolution?

Craig DeDomenico, Stifel: Clearly tech IPO issuance is the lowest it’s been in seven years. It’s running about 10% of the calendar, which isn’t great for the IPO business. What’s clear is that tier one mutual fund PMs are willing to invest in companies that are IPO-ready now and help them stay private longer, fund their growth projects and even monetisation plans in the private markets.

What’s also important to note is that for those companies that are both cash-flow positive and IPO ready, there’s also a more willing private debt market which enables them to thrive. There are now approximately 100 private companies with billion dollar-plus valuations. In June, Stifel hosted a private company conference in NYC and we talked about how Google went public at a US$20bn type valuation in 2004. You now have Uber with a US$50bn valuation and still remains a private company.

So do many of these unicorns go public at some stage? The market will tell us over time, but yes, I believe most of them will go public. My main point is historical illiquidity concerns on funding IPO-ready private tech companies has dissipated as institutional investors are willing to invest earlier.

We’ll continue to see software companies accessing the public equity markets. We have one that just filed and one that’s getting ready to launch. Clearly all of us on this panel plan to compete for these large tech IPOs as that’ll be very lucrative.

Brett Paschke, William Blair: What has clearly happened is the private and the public markets are merging. Even 18 months ago it wasn’t a constant topic in every one of your meetings with a private company and/or their VCs or boards. Now it’s very much part of the discussion: should we do a private round? What do you think the valuation differential would be? Does that help or hurt an IPO?

Mutual funds have been looking for alpha by finding potentially very large winners earlier and in advance of IPOs and playing the valuation differential. That second element is going to get washed out as the IPO market catches up to that strategy.

T. Rowe Price is the classic example of a mutual fund complex that pioneered the process. A lot of their outperformance comes from relatively few investments and from very early companies they end up generating massive alpha for their overall fund. That’s still probably going to be a permanent part of their fundraising process.

From an IPO and broader market perspective things like Uber can be very distracting. It reminds me of when Facebook had that private secondary share listing market going on and everybody thought there was going to be a whole market for secondary shares.

We’re getting to big numbers on unicorns now. A lot of those valuations are pretty questionable if you ask me because they’re very small percentages of the companies that are getting sold and they’re ascribing an overall valuation on a 5% investment and saying it’s like a billion dollars. Plus I think some of that stuff will moderate but we will have a blurring.

Most banks now are addressing pre-IPO crossover investors as part of the capital raising process. Private funding has become more institutionalised over the last couple of years. There has been a little bit of disintermediation. A lot of funds went direct or just met people on some of the non-deal roadshow or “test the waters”-type meetings, even set up through some of the PR firms. There’s not a lot of structure around the process which has some pluses and minuses depending on how sophisticated the investor is.

IFR: Do the terms of those private rounds include registration rights or other mechanisms that would obligate the company to go public?

Brett Paschke, William Blair: They would always negotiate the terms. Most of the mutual funds don’t want board seats, but they do usually have downside protection and ratchets and the like. Another thing that I don’t think gets captured in the valuation discussion is what protection those equity investors have for a very small percentage stake. That’s the part you don’t see.

You’re just starting to now see disclosure around some of these things and a little bit more advanced form fee disclosure, term disclosures, timeframes, some of the rights. There was about an 18-month dark period where all you would see was the headline, the company, the investor, the amount and implied valuation and nothing else. There has been some increased sophistication surrounding disclosure.

Craig DeDomenico, Stifel: It’s important to note that a lot of the name brand PMs, they’re not really looking to take venture risk unless the name is obviously going to be a sure winner. In general as I said earlier, a lot of these companies are perceived as relatively IPO ready and therefore they’re just choosing to stay private and take advantage of private capital.

Obviously the ability to attract brand name investors in a private round prior to the IPO is something we’ve always seen in the healthcare markets. I think that passive institutional type validation is also now more of a focus in technology.

The average timeline from infancy to an IPO is now something closer to a decade for some of these tech companies whereas in previous tech booms, it was more like four years to the IPO. These companies are staying private and that capital has become more efficient. We’ll see what happens if the market is more volatile in the future.

IFR: Frank, the private/public market overlay is not necessarily a new phenomenon. We saw some of this pre-crisis through alternative listing platforms like the GSTrUE and Nasdaq PORTAL. In some cases it led to fairly sloppy execution of some IPOs. Do we face a similar risk with some of these privately funded companies when they eventually look to go public?

Frank Maturo, UBS: It’s hard to say. To see the institutional investors get into the private market, that is what’s been the big change, both on the healthcare and tech side. Whereas before the private market was dominated by sovereign wealth funds and pension funds, now you’re seeing the institutional investor jump into the private market much more over the last five years or so.

So I don’t think it’s going to end badly. I just think the returns might not be as great for those institutional investors as they were in the past. That’s going to be the difference.

IFR: It’s quite a bit different with healthcare Jim in terms of the speed of the private to the public round. I don’t know if you can talk a little bit about that and what impact the crossover funding has on biotech IPO bookbuilds?

Jim Cooney, BAML: Just quickly back to the Apollo example. So Apollo and Oaktree, both alternative asset managers, listed on GSTrUE, Apollo sold about 11% of its market cap publicly. The rest of its shareholders were not interested in paying 6% to sell and/or be locked up. So that’s what led to a very volatile first couple of trading sessions. Oaktree went after and learned a lot of lessons and I think they structured the deal in a manner consistent with better execution.

That was specific to GSTrUE and we’ll leave it at that.

With respect to healthcare your point is well made. So first of all the crossover investors for the most part tend to be longer term in orientation because, to your other point, they tend to be buying approximately six months prior to the IPO.

So if you think about all the good healthcare IPOs predominantly in biotech that have happened over the last three years, the average step-up from the crossover round to the IPO midpoint on the cover is about two times. The average timeline between the crossover investment and the pricing of the IPO is about six months.

What we’re not seeing is investors buy the crossover round for the IPO exit despite the immediate step up from the last round. These investments tend to be longer term given the rounds are led by public oriented funds who seek exposure throughout the entire life cycle of the drug development process. Positive data events followed by approval is ultimately where there is significant value creation.

Tom Morrison, Blackstone: Sometimes in these transactions when you’re talking to new public equity investors, they want to know what the situation is with private-round investors. Are they locked up or not? That can impact their interest. That can impact any supply that’s created in the aftermarket.

IFR: Brett, you are familiar with the FINRA research rules and recent changes in those rules. Can you give us an overview of that and the implementation of those rules for William Blair specifically versus for firms that were part of the global research settlement?

Brett Paschke, William Blair: What’s going on through various iterations between the global settlement around the dotcom bust, the Toys”R”Us settlement earlier this year, the Jobs Act a couple of years ago, the publication of FAQs by both FINRA and the SEC is an attempt to codify the role of the research analysts in the new business development process, the pitch process, the IPO process itself and the marketing, and when they can issue research.

One of the real frustrations for really all the practitioners regardless of where you sit is without question is that there is a lot of confusing and conflicting inputs across those various rule making bodies.

There’s also in my opinion some recognition, some negative political undertone where FINRA and SEC have worked against things that came out in the Jobs Act, particularly on the research side. It’s been pretty frustrating.

What people lose sight of sometimes on this topic is what we are trying to achieve. What are we trying to achieve was to have issuers and board members selecting underwriters who know who the research analysts are going to be, and what they cover and what value drivers they view as important.

The Toys”R”Us case was a very rare exception. It is a deal by the way that never got public. The case centred around the promise of positive research as a condition for getting on the transaction. I just don’t think you see that type of behaviour really across the market very often. In order to avoid potential conflict, regulators keep making the role that research analysts can play more and more narrow.

Personally I think it’s very valuable for a board of directors of an issuer or a private equity firm to hear from potential research analysts that may or may not be covering a company as you think about the message being sent to the market, the key themes, the value drivers and all those things. It’s become very difficult to do that. Then you get an emerging growth company that is still protected in terms of research analyst participation in a pitch by the Jobs Act. A set of FAQs came out that really narrowly defined what it means to participate in a pitch.

Then you have different firms at the table that are part of the global settlement and other firms that are not. If you’re not part of the global settlement you have more ability to have your research analysts play a prominent role, but then you’re trying to interpret some of these conflicting roles.

Right now it’s frustrating for all participants. You get research analysts who are less informed because they’re being excluded. You have issuers and (independent investment banks) that are trying to help issuers make decisions, also frustrated because they can have less input. Most importantly, you have a market that is much less informed as a result of limitations put on the research analysts.

It’s a little dated now, but think back to the Facebook IPO. It traded down and then it came out afterwards the Morgan Stanley analyst had changed some of his forecasts because of some things he learned during the roadshow. The only people who knew about it were the institutions that he had direct discussions with. The market was outraged and there was a lot of negative media coverage about the issue. But that’s all he was allowed to do. You’re not allowed to publish your research broadly.

So you keep regulating in this two-tiered market where institutions with access to the underwriters’ research analysts can have that information and everybody else cannot. That was really part of what the Jobs Act was trying to get away from.

The Jobs Act has been very successful on a number of other fronts. But on the research part it’s been muted by all these other forces. The idea that investment banks should only underwrite deals that they think are good deals: that their internal research experts think are priced fairly, are going to trade well, and are going to make people money. To me that is a responsibility of ours.

We shouldn’t be selling things to institutions, retail or otherwise, that we don’t think are priced right, are not going to trade right. We should be behind them and research should be part of the process by furthering investor education.

The problem that we’re solving for is not a problem, it should be our responsibility. If we do it poorly the market should punish us and they shouldn’t hire us for deals that don’t go well.

Matt Sperling, Rothschild: Quite frankly when issuers are hiring any of these banks, they are hiring every element of that bank. You’re not just hiring the smart capital market person or the smart sector banker that is going to help you write a good prospectus. You’re hiring a sales force, you’re hiring the trading platform and you’re hiring the research platform.

In theory at least, as an issuer you have the ability to select whatever banks you want to using whatever criteria. To me there’s enormous frustration on the part of issuers and their owners regarding the question you alluded to: ‘what is the role of research on Wall Street?’

There is a debate that’s ongoing. I’m guessing everyone in this room is probably on one side of the debate perhaps, as to what exactly the role of research is and is there such a thing as truly independent research and are there expectations on the part of investors as to what research is and also what types of investors have access? That’s a debate that’s been going back to the dot-com bubble of the late 1990s.

Frank Maturo, UBS: I remember those days. (Laughter).

Matt Sperling, Rothschild: The analogy I use a lot of times is this: you walk into a car showroom and someone hands you a brochure as to how terrific that station wagon is that you might buy. It’s obviously going to be a 20-page glossy brochure about how terrific the thing is. If you want, you then can go to Consumer Reports and you can get an independent perspective on all of that. Something that got lost a long time ago is who do the analysts work for? What are the internal processes and is there such a thing as an Ivory Tower?

Brett Paschke, William Blair: The market can punish an underwriter immediately for doing bad work. If you put out glossy research on a company that turns out to be terrible and loses investors money, they can punish you by not buying any more deals you work on. They can turn off trading on your trading floor. The minute they decide you did a bad job they can make it broadly known amongst the issuer community that the deals you worked on aren’t effective.

There is a very real and effective way to protect against the behaviours (regulators are) trying to protect against.

Matt Sperling, Rothschild: I agree, and also what is lost is there are examples of egregious behaviour and you do have to have rules to prevent egregious behaviour. You can’t be printing one thing and then privately telling people other things. You can’t do that. You can’t be coercing people to do one thing or another.

Fundamentally we are all now living with the current approach of the regulators, which isn’t making things more transparent honestly. It’s just resulting in enormous levels of frustration on the part of the owners, on the part of the banks, and on the part of the analysts. We’ll run bake-off processes where five or 10 banks will come in and we know what is and what is not allowed. Nothing is ever untoward. You just now have five or 10 different perspectives from the banks, the bankers and the analysts on what types of conversations you are allowed to have. At the same time, the issuer is very frustrated because they don’t understand why they aren’t allowed to ask an analyst what he or she thinks of the sector currently and the companies covered, and what he or she has in terms of preliminary thoughts about the issuer, both good and bad, and is this the type of company he or she would want to add to his or her coverage universe. After all, it’s the issuer hiring the analyst and these seem like fair questions.

Brett Paschke, William Blair: It’s never been more confusing than it is right now. The most recent FAQs have undermined a lot of the clarity we had previously.