IFR: I would like to move on to Spotify and its direct listing in April. Carolyn, can you walk us through the direct listing process and the regulatory approvals that it made it possible?
Carolyn Saacke: The process actually started a couple of years ago with three bulge-bracket investment banks calling me within 48 hours, asking “can we do a direct listing of a really cool company without any IPO?”
On the first call, you tell them what the rules are and you’re like, okay. The second call hits and you’re like, interesting. Then by the third call, you realise something is up.
It took a couple of years for us to work through the regulatory process. We worked with both the SEC and Spotify for quite a long time.
We looked at the rules that we had in place: you can list an IPO this way, you can transfer a listing this way, and this is how other types of securities can be listed. But we didn’t have anything in place that would allow a direct listing like Spotify.
We spent many, many months working through multiple drafts before the SEC approved the direct listing processes in February 2018.
The rule allows a company with a market cap greater than US$250m, with at least 400 shareholders, and 1.1m shares outstanding to directly list. A company also is required to have an independent financial adviser.
The direct listing rules are very similar to what are required for a traditional IPO, with similar protections such as for retail investors.
Just looking at the public filings and the media coverage, it appeared that there was a clear track being followed once the direct listing process was approved.
But there was a lot of work being done behind the scenes. There were three financial advisers that were working with Spotify. Citadel Securities was hired as the designated market maker and floor specialist. Spotify was working with its financial advisers for three months.
There were a lot of complexities. Multiple shareholders, both institutional and retail, that did not actually own a tradable security, so all of them needed to be set up with accounts.
You need to make sure that there are enough shares that you can actually short the stock, if investors wanted to, after the listing. There were so many steps along the way that made this possible.
The good news is that all of the regulatory steps for a direct listing are in place. The next one is going to be much easier. As a side note, the SEC direct listing rules can be used on both NYSE and Nasdaq.
James Dunning: Carolyn, a quick question. How much of the success do you believe was based on the fact that it was Spotify?
I mean everyone knows Spotify, even my parents. I can walk through Times Square and ask who knows Spotify, and every single hand will go up.
Some of the unicorns, even the tech unicorns, are not as well-known as Spotify.
The plumbing and infrastructure for a direct listing are in place, I get that. But how easy will it really be for the next company to directly list?
Carolyn Saacke: You are absolutely right. There are a few things that made Spotify special and that made its direct listing work. They had breadth of investors, many of whom had been there for a long time.
There was a lot of marketing by the financial advisers to gauge interest from those investors; whether they were going to stay put and that not everyone would sell on day one. That everyone was able to sell was a big concern. On the other hand, you do want some selling by existing investors to create liquidity, because there is not an actual offering [of new stock].
From a research perspective, Spotify already had coverage before their listing; they are such a big company that has been around for a while. They also provided a lot of financial forecasts as part of the direct listing.
You also have to remember that there was an active grey market in Spotify shares ahead of the direct listing on NYSE. In the first 10 days of March, the average daily trading volume in the grey market was 500,000 shares, which is huge for a private company. The average price on those grey market trades was about US$132.50.
The night before the direct listing, the financial advisor put out a reference price of US$132. Yes, the reference price was influenced by trading in the grey market, so there was a little bit more certainty around valuation.
Matthew Sperling: One other key to Spotify that is unique, well relatively unique, is that it is still growing despite being such a large company. They did not need to raise primary capital. If they did, Spotify would have been in regular IPO land.
Rothschild advised one of the major corporate owners on Spotify. We also advised another consortium of independent record labels.
I do believe that Spotify will end up being a relatively unique set of circumstances that will not apply to as many situations as the news headlines would suggest.
Having said that, kudos to Spotify and the financial advisers for pulling off the direct listing. The press and everyone was ready to write their “Facebook trading debacle story” if it didn’t go well. It did go quite well.
It is important to compare the direct listing process to a traditional IPO. While a traditional IPO is not perfect, we spend a lot of time talking about ways to improve the process, and how to make the process more transparent.
A traditional IPO bookbuild has a cadence whereby some of the variables are fixed up front in terms of supply, an approximate notion of value, and then an orderly process that investors can choose whether they want to invest and at what price.
There is a negotiation between investors and a company’s owners and management. “I’m willing to accept your offer and buy at your price or here is my counteroffer.”
Of course, there are all sorts of dynamics around those negotiations and the process is fairly opaque to begin with. But one of the things that made Spotify particularly complicated, and again, they pulled off the direct listing, is that what normally is a week-and-a-half long process was mashed into three hours in an open outcry auction process.
There was no feedback loop and no variables fixed.
Essentially you had owners sitting there saying, “I have a grid in my mind, I’m willing to sell X at this price, maybe Y if it’s at that price”. And you had the buyside looking at this, saying, “I’m willing to buy X at this price, and Y at that price”.
Ultimately, somehow, they needed to meet in the middle. Having spent hundreds of hours on this, I think the success of Spotify’s direct listing is best evaluated when compared to a more traditional billion-dollar-plus tech IPO.
And, even though the stock has since obviously performed, the near term was a little bit more dicey. You had a stock that opened very high and traded down 15% on day one.
Everyone talks about retail and that everyone knew Spotify. The reality was retail participated very little in that transaction. Why?
Most of the banks turned their retail systems off because the argument was we don’t have the information as to what’s actually going on and so we’re not going to let our financial advisers loose and put grandmas and other clients into this deal.
So, Spotify ended up with only USS$1bn of liquidity on the initial trade, whereas the hope was that there would be more. And, that liquidity dried up pretty quickly.
Carolyn Saacke: Actually, I have to disagree with that. The opening was very similar to what you would see on a traditional IPO. On a traditional IPO, a stock opens based on indications that come in throughout the morning. That opening price is not likely to be the price that was set on the IPO the night before.
There is an iterative process based on conversations between banks involved in the underwriting syndicate, the designated market maker or floor specialist, and all of the traders involved. Based on those conversations, the bid-ask indication moves, and narrows over time.
In the case of Spotify, it took about an hour for that first range of indication to be published. The first indication was a US$10 spread, which for a US$132 stock is not too shabby.
There were eight more indications; the last one was a spread of US$3, which signalled to the market that we are ready to go, that the opening was going to be within this range.
There were certainly some that suspected some of the sellers, were like, “Well, we’re just going to wait and see how high the stock goes on the open”. They started selling a little bit when the stock hit their targets.
Matthew Sperling: I agree. The whole objective was to get that initial float large enough to balance buying and selling. But if you look at Alibaba, who Rothschild also advised, there was US$25bn of float trade in the first day.
Frankly, one of the biggest challenges for Spotify would have been if some of the large shareholders decided to sell less in a way that no one anticipated. There is, obviously, human emotion involved throughout all of this.
We were in the frontlines. You could have had a situation where the first-day volume was double what it was; or where it was one-quarter, say only US$250m. If it were the latter, a lot of people would have been writing, “Oh my God, the deal failed”.
Arguably, that is a risk that some companies and owners may not want to take.
I completely agree that the plumbing has been fixed. There are a lot of elements to the Spotify listing that are positive. If you look at what Spotify management have said about the process, they certainly achieved some of the objectives they had hoped for from the direct listing.
Spotify’s direct listing certainly affects the conversations that issuers can have with investment banks on a traditional IPO. “Look, we are going to get covered by as many people because of who we are. We are going public through a syndicate of four bookrunners but we expect another 25 will cover us.”
Then there is the concept of an IPO discount – Spotify talked about how they did not like the notion. One could argue the discount is not the same for every transaction. Certainly, larger IPOs tend to have smaller discounts. If you are an issuer and you have that size dynamic on your side, that’s a positive. Pricing above range obviously narrows the discount.
Going one step further, a company could approach the underwriting banks and say, “We are not giving this away. We are going to price our IPO where the market is”.
There will be a more open dialogue going forward between issuers and their underwriting banks around valuation. Investment banks may not like it, but the discount may smaller.
IFR: Certainly, there was an element of democratisation of capital behind Spotify’s decision to directly list. Google had a similar motivation when it went public through a Dutch auction bookbuild all the way back in 2004. Google’s IPO process was flawed in many ways, and we really haven’t seen companies go public via an auction since then. I think we can all agree there are growing pains with such innovations.
Matthew Sperling: The market doesn’t like uncertainty. And in the context of pricing deals, the market likes to think things through in an orderly process. What is the valuation discount? What does the book of demand look like? Where is this stock going to trade in the aftermarket?
The notion of having a lock-up in place is, arguably, an important tool to bring investors to the party. Basically, the investor understands that if I’m buying this I know that I have got 180 days. Obviously, if the stock performs, the company or its shareholders may go to the underwriting banks and request to be released from the lock-up.
But there are norms. In the case of Spotify, there were uncertainties surrounding how the book of demand was being built and how much supply there would be at any given price in such a short period. Again, it worked, there is no doubt.
Personally, I do not believe [a direct listing] is going to be replicated in as many situations as others believe.
I can only speculate that the buyside institutions that bought on that US$1bn of liquidity on the open were not happy to see the stock trade down 15% on the first day. Obviously there had to be sellers on that opening trade.
Carolyn Saacke: There is a reason why the IPO process really has not changed that much in 30 years: because it works.
The NYSE does like that there are companies exploring alternatives ways to go public. We do need more public companies in the US. There are a lot of advantages to being public.
The direct listing was an interesting way for this one company to go public. Maybe we’ll see some more companies look to directly list, or maybe just borrow different elements from Spotify’s process.
IFR: One element that allowed Spotify to directly list was that there was already a deep, liquid private market in their shares to facilitate liquidity. The SEC has recently discussed broadening access to private capital to a greater number of investors. Anna, what is the latest you are hearing out of the SEC?
Anna Pinedo: At a recent speech in Nashville, SEC chairman Jay Clayton talked about looking at ways more retail investors could be brought into the private markets.
This is a theme that we’ve heard over and over from the SEC - too few public companies, an over-reliance on private capital, and private companies experiencing significant growth while private. Their preference would be for companies to go public and allow the general public to participate in or benefit from that very significant growth.
Clayton’s point is that the vast majority of investors are unable to participate in private placements because they are generally limited to large institutions and accredited investors.
It becomes a line in terms of loosening regulatory burdens surrounding private capital or making it more appealing for companies to go public.
Is that initiative ultimately going to go anywhere in terms of not having an accredited investor standard? Unlikely; I don’t see that changing.
The SEC came out with a study on the accredited investor definition. Congress, at least on the House side, passed what’s referred to as JOBS Act 3.0, though the legislation has yet to be considered by the Senate.
JOBS Act 3.0 has a provision that would modify the definition of an accredited investor to broaden the scope. It would not broaden the definition in really significant ways that would be impactful, in my opinion. The provision would allow individuals, regardless of net worth and net assets, who have certain accreditation, such as CFAs, CPAs, or certain brokerage licences, to qualify as an accredited investor.
At the periphery, that could make a difference expanding participation in private placements.
But fundamentally, you have to question whether there’s really a problem. I would argue that a lot of crossover funds – and we have already heard that crossover funds are very actively investing in promising growth companies – provide retail access to private capital.
Even if that access is disintermediated through a crossover fund, retail can still participate in those growth opportunities.
IFR: What other aspects of JOBS Act 3.0 should we think about?
Anna Pinedo: JOBS Act 3.0 would generally be quite positive for the market. For example, it would expand the ability of pre-IPO companies to test the waters beyond emerging growth companies (EGCs). So, all companies would be able to test the waters.
I think everyone on the panel believes that testing the waters is a useful process.
The legislation would also extend exemptions for smaller companies with lower revenues to Section 404(b) attestation under Sarbanes-Oxley. [Editor’s note: Section 404(b) obligates management to attest to internal controls over financial reporting].
Life sciences companies, which Mayer Brown frequently represent, would fit within that low-revenue issuer category. They would not have to dedicate valuable resources to the 404(b) attestation and could defer that obligation for a significant period of time.
Fundamentally, I think that is very useful.
Another significant point contained in JOBS Act 3.0 is quarterly reporting. A long time before President Trump’s tweet about abandoning 10-Qs, the legislation had put measures in place that would require the SEC to conduct a study to evaluate the merits of quarterly reporting for EGCs.
The SEC would also be required to carry out a study on research coverage and how to promote additional research for smaller companies.
We have not really talked about research today. For many smaller companies, going public is a very expensive process that provides little assurance that they are going be covered from a research perspective. That weighs heavily on management.
IFR: Craig, do you have thoughts on research coverage for smaller companies?
Craig DeDomenico: If you look at the traditional IPO process, underwriting syndicates have gotten larger, not smaller. I would argue fees have gotten lower, not higher.
But there is no doubt that an IPO is a material, expensive event, between fees paid to lawyers, auditors and investment banks. And, frankly, going public takes a lot of time. It is a high-cost event.
There are reasons that companies raise money privately, and one of those reasons is that they need money to go public.
Whether a company goes public through a traditional IPO process, through an up-listing, through a bankruptcy reorganisation, or by a SPAC merger, it comes down to the same blocking and tackling.
Management teams need to make sure that they have the processes in place to be a public company, that they are comfortable with quarterly earnings, guiding investors, and accountability to their board of directors; that they’re ready to be a reporting company, that they practice being IPO-ready, that they treat projections and the board and their quarterly reports that way.
I think smaller companies can get public in the current market backdrop, as long as there is a story and there is growth. If you look at a US$60bn IPO market this year, there are about 200 companies, so it is not only mega-caps.
Middle-market companies continue to dominate the IPO calendar. Those are our clients and, ultimately, there is a lot of time spent by investment banks and lawyers to help them stage and prepare for going public.
I do believe it healthy to think about the process going forward. At one time, testing the waters used to be a bogeyman for some firms. Now, all firms see it as valuable.
We could see roadshows shrink in size by a day or two, depending on the type of company and objectives but I do think the current process is relatively efficient.
Ultimately, the hard part of our job is picking the right companies [to go public] and turning down the ones that should wait. But there’s nothing like pricing a successful IPO in terms of a relationship with a company.
IFR: Matthew, what is your outlook for the rest of the year and into 2019?
Matthew Sperling: Clearly, we are off to a strong start after the Labor Day holiday, as everyone expected. It will be interesting to see if and when the midterm Congressional elections [in November] start to affect the calendar.
Arguably, the post-Labor Day start would have been stronger, but the physical calendar in terms the holidays has made it a little bit more complicated. There is a lot of high-quality product. There is also a lot of cross-border activity.
Flavours come in waves. The question, of course, starts to become whether the third, fourth or fifth similar transaction is digested as easily as the first. I believe that we could see some indigestion and that some of that could be driven by volatility in and around the midterm elections. If conditions aren’t disrupted in November, then we should see a strong finish to the year, which would set up 2019 very well.
Predicting what will happen in November is pretty impossible to do. There are certainly lots of prognosticators talking about, “If you have split congress or if you have one branch this way and the other that way and then the presidency that way, what could that mean more generally?” We will see.
IFR: Carolyn, what is the NYSE seeing in its pipeline?
Carolyn Saacke: I completely agree with Matthew about the midterm elections. If you look at our calendar, September and October are extremely busy. Everyone wants to get out before the elections.
Typically, at this time of year, there would be companies saying, “I’m aiming to go in December”. This year, everyone wants to go beforehand and give themselves that extra bit of cushion.
It is going to be a very strong end to the year. Obviously small transactions are getting done, but there are also some big deals, some bigger brands, some names in industries that we haven’t seen in a little bit.
It should be a really good year and hopefully, knock on wood, that will lead us into a really good 2019 as well.
IFR:Excellent. I would like to open it up for questions from the audience.
Audience: Diving a little deeper into cross-border listings, particularly out of China. What is really driving that deal flow? How do you differentiate between all of the investment alternatives?
James Dunning: You’re right. We have seen a ton of new paper coming out China, and our understanding is there is a lot more in the backlog.
For J Goldman, we really do look at those companies on a case-by-case basis.
We want to make sure that a company is sizeable enough that it is not going to become a public orphan. That it will have research coverage from Asian or US analysts, so that it will have the right investment community following the story.
There are going to be some big deals coming down the pike that we believe will be very well received, assuming the valuation makes sense.
There is a bifurcation at the smaller, sub-US$500m market cap Chinese companies, where investors are a little bit more discerning.
If you look at Pinduoduo [US$28.5bn market cap Chinese e-commerce platform], Nio [US$8.3bn market cap], or iQiyi [US$19.6bn market cap Chinese social media platform], they are well above their IPO price.
But some of the sub-US$500m, or maybe even US$1bn, market cap companies have been left as public orphans.
There are a lot of education companies that are going public that can be hard to differentiate. The fourth, fifth lookalike might not be as well received as the first or second, especially if the first or second is trading below where they went public.
Craig DeDomenico: It only takes one or two to earnings misses out of the gate for investors to lose confidence. Scrutiny to meet earnings expectations is more intense for foreign companies. That puts pressure on investment banks to ensure we are bringing the right type of companies to market.
Investors can lose patience really quickly, particularly with small-cap companies.
James Dunning: Cross-border transactions are always going to be trickier. But I do believe companies and underwriting banks are doing the best they can to minimise risks.
There are a lot of high-quality cornerstone investors that are putting real money behind some of these companies. And they are not the same cornerstone investors over and over again on every deal. There is a nice breadth, whether it’s strategic out of Asia, US long-only mutual funds, reputable global hedge funds, or sovereign wealth funds.
Just like with smaller-cap or biotechs, it really helps to have dedicated industry expertise that participate. Having a deal insulated with insider buying helps, going back to supply-demand dynamics that are important on every IPO.
Audience: My question is about private markets. What role do investment banks play in facilitating liquidity? Are there specific exchanges that make a market in private stock?
Anna Pinedo: Yes, there are organised markets. Nasdaq, obviously, through the Nasdaq Private Market, sponsors trading in pre-IPO companies. Those are generally company-sponsored liquidity programmes.
There are smaller venues, such as EquityZen, that will facilitate trading and will post pricing for transactions that are executed in privately held companies. Some of that information is publicly available, particularly to accredited investors.
Away from organised venues, there are negotiated transactions that broker-dealers will facilitate, particularly if they have agented a private placement for some of those companies. They will facilitate trading off-exchange, not through a Nasdaq Private Market or through any other vehicle, to find buyers.
For a lot of the large private companies, there is significant trading.
Matthew Sperling: In the case of Spotify, there were a number of investment banks that were making a market in the stock before the direct listing. They were deliberately speaking with all of the potential sources of supply. Those discussions helped create transparency among the advisory group as to when and how trades were happening.
Akram Zaman: Many of what you would consider public market institutions, mutual funds that buy our IPOs in size, were all holders of this grey market or private security. That was very, very interesting, and it allowed this facilitation to happen.
Matthew Sperling: That is a very good point. When you talk to the key banks that were advising, there was a lot of uncertainty as to what the aftermarket buying would be because a lot of the funds that would be traditionally buyers in the aftermarket already owned stock.
Audience: What type of activity are we seeing from private equity firms?
IFR: Sponsor-backed IPO volumes are down about 50% so far this year.
Matthew Sperling: There was a period of time with [Apollo Global’s] Leon Black talking about, “We’re selling everything that’s not nailed down”. Some of the lower issuance we have seen is the natural cycle of many firms monetising everything that was monetisable. Other IPOs that were in the works ran a dual-track process and chose to be acquired rather than go public.
ADT was certainly one IPO that a lot of investors were clearly not happy about. But I’m not sure that investors hold grudges against a particular private equity owner.
If there is a high-quality company, with a great investment story that is priced right, rarely would you see an investor say, “But it was brought to the market by X, Y, Z and I don’t like X, Y, Z”.
They might ask tougher questions, they might poke the underwriting syndicate more strongly around other areas to gain leverage to move pricing down on an IPO.
The slowdown in sponsor-backed IPOs is also a function of the current cycle.
If you look at the breadth of the IPO market, tech and healthcare are an enormous chunk of it, with more growth equity and deals away from traditional sponsor-backed companies.
Carolyn Saacke: The same sponsor [Apollo] behind ADT did another transaction [PlayAGS] just one week later that performed really, really well. Everything is going dual-track, and so we had sponsor-backed companies that were lined up to go public that have since been sold.
IFR:Thank you everybody for coming today and thank you to Stifel and Mayer Brown for sponsoring the roundtable.