IFR: Welcome everyone to IFR’s ECM Roundtable. We have heard a lot of discussion from the SEC, and elsewhere, about how access to private capital negatively affects IPO activity. Anna, with IPO issuance up more than 20% for the year on volume, and by one-third on number of listings, do you think the pendulum has finally swung from private capital into public equity markets?
Anna Pinedo: Oh no, not by any stretch. We are certainly seeing a healthy IPO market, and while that’s something that all of the panellists are very happy about, there is no shortage of private capital. We’re seeing enormous amounts of private capital being raised, particularly for tech companies.
The dynamic that has caused so much consternation for the SEC, regarding the overall decline in the number of US public companies, I don’t think that that’s changed or that it’s changing anytime soon.
So long as there’s private capital available, at attractive valuations, a lot of household names are going to stay private for as long as they can.
IFR: Thinking about how private market valuations extend into the public markets, software companies have been an important source of outperformance in the public markets. Craig, can provide some perspective on valuations for technology and software companies?
Craig DeDomenico: Obviously, investors want to buy IPOs at an attractive valuation. They’re hoping to get performance in the aftermarket.
If we look at the IPO asset class year-to-date, it’s up around 20% and we are on pace for something like US$60bn and potentially as many as 200 IPOs. That is obviously a pretty healthy market. But in order for that to be sustainable, the asset class needs to outperform the broader markets.
Nasdaq is up 17%. A good portion of that performance is coming from the technology universe. Ultimately, a portion of that universe that is driving performance has been software.
Four to five-time revenue multiples on software deals feels like a tough entry point. But the reality is the quality of the software IPOs that have come to the market this year is very high, and deals have performed well.
It reminds me of what we saw in 2014, where you had a very high-quality group of software companies become public. Again, similar valuations, and investors ultimately made a lot of money.
Whenever you’re buying an IPO, you’re taking risk on those projections and meeting expectations, as is the case with all newly public companies. Software companies help de-risk some of that volatility because they have predictable business models.
There is also an M&A floor underpinning software and that provides some downside protection to operational missteps. A larger average deal size [for software] also results in improved trading liquidity.
Overall, the IPO market has benefited from a wider variety of industries going public. The only industry that is tracking down year-over-year, in terms of number of IPOs, is consumer. We all realise why that is.
So it is a pretty good backdrop overall. As long as the asset class continues to outperform, we will continue to see a pretty healthy IPO market moving forward.
IFR: There are times when companies fail to achieve a valuation on their IPOs that they did on their last private raise, a so-called down-round. Akram, how challenging are down-round IPOs?
Akram Zaman: If a company is simply looking to raise capital, the private markets are obviously there, and very accessible, particularly for the higher quality companies.
But it’s important to consider that there are other reasons to go public: creating currency for acquisitions, incentivising employees, raising the company’s profile. Maybe the management team just wants to go public. There are a number of different factors.
Having said all that, generally there is a valuation concession required to go public, an IPO discount.
Nevertheless, there have not been too many IPOs of late that have been a down-round [to their last private valuation]. We’ve had a very healthy backdrop in US equity capital markets.
There are cases where there will be down-round IPOs, but again that may be because there are other motivations for going public.
When we speak to potential issuers, most want to go public at the valuation they got on their last round at least, ideally above that.
If the market were to roll over a bit and valuations come in, we could see the dynamic of down-rounds become more common.
James Dunning: The bigger test could happen next year, when we see some of the brand name tech companies that are bringing billion-dollar-plus deals at US$10bn-plus valuations.
This year, we have seen smaller-sized IPOs in the software and tech spaces.
There have not really been the big brand name private companies that have raised capital at super-rich valuations. Some of those could be forced to accept a discount. We are all in a bit of wait-and-see mode.
IFR: James, are you concerned about software valuations right now?
James Dunning: In general, no. We are in a market where investors are differentiating.
Some software companies are truly disrupters that are growing extremely fast. Those that have demonstrated a path to profitability trade at very high valuations – seven or eight times forward revenue.
It makes sense for those companies, if they are not going to get acquired, to access the capital markets.
Some software companies that are growing revenue at 20%, 25% annually trade at around five times. That is a historically high multiple for software companies.
Overall, we think investors are doing a good job of differentiating high-growth, premier software companies such as Zscaler and DocuSign from others that do not have the same level of growth or market opportunity but are still well run.
IFR: Craig, how have we seen those opportunities play out in the convertible bond market? Why does it make sense for investors to consider a CB and is that market overheating a bit?
Craig DeDomenico: Convert originators have been waiting years for this rally. A big reason for accelerating deal flow is companies terming out floating-rate debt exposure as we have seen interest rates rise. That accounts for about half of what we have seen in terms of new issues.
The other half is really coming from the technology universe, many of which went public in the 2014-2015 timeframe. A lot of those companies are funding in the convert market.
A lot of these companies don’t really need the money. They are locking in funding at 1% or sub-1% rates. That low-cost capital is supportive to their valuations.
Convertibles are a great way to pre-fund balance sheets for M&A. A lot of the big banks have been pressing that theme: Instead of straight debt and bank debt, which carry covenants, load up the balance sheet by issuing a CB.
If you can go to the board and tell them, “Rates are rising but we can get funding at a sub-1% coupon, which we can carry and earn more on interest earned from cash, with stock dilution at a 30% premium to a stock that is trading at five, six times revenue”, that is a pretty good funding tool.
A lot of what we are seeing in the convert market is related to that pre-funding theme.
IFR: 2014 was a memorable year in the IPO market. Biotech was a significant portion of deal flow then and remains an important source of investor outperformance and deal flow in 2018.
Steven, what is driving the level of issuance we have seen and is it sustainable?
Steven Tuch: The last time we had a downturn in the life science market was in November 2015 and January 2016, when Hillary Clinton tweeted that she was going to legislate lower drug prices.
[The threat of lower drug prices] had nothing to do with the quality of the companies and returns investors were making on IPOs. That threat did impact investor perceptions of the economics of drug development.
It took the market a long time to get out of that rut.
The positive shift in investor psyche happened well before President Donald Trump was elected [in November 2016].
Investors started to become more comfortable before then that it was not going to be easy to legislate lower drug prices.
Biotechnology is a little bit different than, let’s say, the software market, because there are macro issues.
The saying about biotech is that the second pill costs 10 cents and takes one minute to make, but the first pill costs US$600m-$1bn and takes 20 years to make.
There is always going to be a need for capital. The question is, “Will you get it from the public markets or will you get it from the private markets?” You prefer to get it publicly, because it’s a cheaper form of capital.
Access ebbs and flows on science. And it ebbs and flows on investors’ appetites for later stage versus earlier stage.
I cannot predict what is going to happen after the midterm elections [in November]. I also cannot predict the investor appetite will be after the JP Morgan healthcare conference in January.
Biotech is a sustainable market because it is so capital-intensive, and it has been performing. Overall, biotech IPOs are up about 20% on average from pricing. That compares with a 10.5% gain for the [Nasdaq Biotechnology Index] and an 8.6% return for the S&P 500.
If you played every single biotech IPO, you are outperforming the market significantly. It is not that way every year, but it is this year.
I would like to think that the markets will remain receptive to biotech IPOs. But I can assure you if the public markets aren’t there, there will still be biotechs that need to raise money.
James Dunning: Think about both tech and biotech. Investors are generally predisposed towards growth and companies with technologies that are disruptive. That is the type of IPO product that investment banks are bringing to market right now. Some of the biotechs are trying to develop cures for certain types of cancers. In the tech space, companies are changing the way business is transacted. That’s the new economy investors want exposure to.
Tech and biotech have outperformed the broader markets. That is the type of alpha-generation you can get from IPOs.
Banks have also done a great job at mitigating risk for biotech companies that are coming to market.
On a US$75m-$100m biotech IPO, typically US$25m-$35m is spoken for by insiders when they launch.
The ability to test the waters as part of the JOBS Act has helped issuers get comfortable before they launch IPOs. That is a big deal.
Everyone, from bankers to corporates and investors, is on the same page by the time a biotech wants to go public. And everyone is aligned in terms of exposure that a company is asking us to absorb.
Steven Tuch: I agree. An important part of the success of the biotech IPOs is the JOBS Act.
The JOBS Act has been really instrumental in allowing companies to educate investors. It was not meant to pre-sell an IPO. There is no jumping the gun. It is about really educating investors.
If an investor is meeting with a biotech for the first time on the IPO roadshow, they are not investing. I firmly believe that.
We have had corporate clients that have done 15 testing-the-water meetings, and we’ve had clients who have done 80. And the ones who do 80 end up having better results.
By the way, I’m not recommending a company do 80 meetings. Maybe 25-30; 80 takes a lot of time.
Investor education is an important factor of the success of the biotech market that is not going to go away.
Matthew Sperling: There is a little bit of a ‘mafia’ element to the pre-IPO biotech funding rounds. Public investors want to see those pre-IPO investors participate in the IPO. It’s a stamp of approval.
Steven Tuch: There are definitely the A-list private investors. From an origination perspective, we do get a lot of pressure from new investors. “Why are we not seeing X, Y and Z investor? Why are we not seeing A, B, C investor?”
The number one reason is that there might be five biotech IPOs and seven follow-on offerings pricing in a week. The last thing they want to do is take a testing-the-waters meeting when they are going to see you in four weeks anyway.
It is a valid point that we do have certain brand name investors that invest in biotech. We have had them for a good 10, 12, 15 years. Some have been spun out [of larger institutions] or start their own shops.
Biotech really has the benefitted from a strong, dedicated investor base. Even in down markets, they know what they know, where they want to be invested and where they don’t. They are not playing a schedule.
They know biotech. Frankly, I believe that during the next downturn they will still be in the market and will make money. If anything, [a hot market] drives them crazy because even inexperienced investors make money.
Matthew Sperling: The quality of biotech companies coming to market is important. In general, we are seeing companies that are in Phase II development or later. If we start to see pre-clinical or Phase I companies, that is where we could see potential pushback from the public markets.
There is a similar screen for tech or software companies that have sub-scale revenue profile, call it US$100m or less.
As soon as we start pushing the envelope, the IPO market could become very fragile.