AT 246 DEALS expected to raise $53.4 billion, the ECM backlog of registered deals is at its highest level on record, according to Dealogic, with IPOs constituting the majority of volume. But while global IPO volume in the first half of the year has soared 372% over that for the same period in 2003, it has been anything but plain sailing. In Europe, especially, investors, vendors, and bookrunners have struggled to agree on valuations and few new issues have performed impressively in the aftermarket.
Concerns that earnings and overall growth momentum are close to peaking in the US, and the crab-like movements of major stock indices, have encouraged listed companies to increase their dividend payments and share buy-back programmes in order to retain investor interest and do something with accumulating cash piles. For companies seeking an IPO, the lack of direction in the secondary market has made it particularly difficult for those without a compelling growth story to enthuse potential buyers and get a decent price for their shares.
Signing the high-yield pledge
Enter the high-yield IPO. This type of equity new issue, which varies in structure from jurisdiction to jurisdiction, could provide a way towards high valuations for stable, predictable and cash-generative companies. Such companies can find it hard to tap the equity markets conventionally because they are also typically low-growth. The idea is that they will attain these valuations by pledging to distribute a high proportion of their future earnings as dividends.
Innovations are few and far between when it comes to IPOs. The high-yield IPO has been around for about a decade in Canada but only made its way south of the border in December 2003 and to Europe at the end of May this year. In the US the backlog of high-yield IPOs is nearly $7 billion, with an estimated additional $15 billion to $20 billion in the pipeline; in Europe, four deals are tentatively in the works.
High-yield IPOs can enable companies using them to attain a valuation of up to 30% more than comparable companies sold in the traditional way. Findexa, the Norwegian directories business sold by Texas Pacific Group in Europe's first high-yield IPO on May 24 2004, was valued at 10 times ebitda, nearly 18% more than that of its closest comparable, Eniro, a pan-Nordic directories company, which trades at about 8.5 times ebitda.
The most striking comparison, though, is that between the Canadian Yellow Pages and Yell, the UK yellow pages business. The IPOs of the two similar businesses both took place in July last year and at C$1 billion (US$743 million) and £1.1 billion (US$1.99 billion) were both sizeable for their home markets. The IPO of the Yellow Pages Income Fund, as the Canadian Yellow Pages listed entity is known, used a high-yield structure, and achieved a valuation, as a multiple of ebitda, at about a 30% premium to Yell.
The Canadian deal, the largest Canadian IPO for three years, caught investors' attention worldwide and established the international reputation of the concept. The success of the IPO, driven by high investor demand, enabled the company to issue an additional C$1.5 billion six months later. Liquidity in the units proved good enough to allow the firm's vendors, private-equity house Kohlberg Kravis Roberts and the Ontario Teachers Pension Plan Board, to sell the remainder of their holdings in a C$743 million block trade in May 2004, one of the largest ever such trades in Canada.
Because the companies best suited for high-yield IPOs are distinguished by their strong cashflows, earnings and cashflow-based valuation models are most appropriate. By promising to pay out a large proportion of cash to investors, companies can get a higher price from buyers that are willing to pay for yield.
For tax efficiency, a high-yield IPO needs to be structured differently in every jurisdiction. In each case, however, it is built around a holding company and an operating company.
In Canada the public is sold units in a trust set up to buy the operating company. Only the owners of the units in the trust have to pay tax. Neither the trust nor the operating company have to pay tax on the cash being paid out because a trust is considered a flow-through entity for tax purposes. There are now 148 income trust funds, as they are known in Canada, and they make up about 7% of the Toronto Stock Exchange's market capitalization. But the elegant simplicity and efficiency of the Canadian structure has not been so easy to replicate abroad.
In order to make high-yield IPOs work in the US, Canadian investment bank CIBC World Markets developed a new class of security. The new SEC-approved security, known as an income deposit security (IDS), is an innovative hybrid debt and equity composite. Each IDS represents a common share and an interest-paying loan note of the holding company, clipped together as a single trading unit by the federal Depository Trust Company. The IDSs can be separated but neither the underlying common stock nor the notes are listed.
The first IDS deal took place in December 2003 and was led by CIBC. The $277 million IPO for Volume Services of America, a concessions, catering, and merchandise services company, offered a 10.4% yield. Priced at $15, each IDS comprised one common share at $9.30 and one subordinated note with a principal value of $5.70. The total yield of the security is made up of an 8.5% annual dividend on the stock and a 13.5% annual interest on the subordinated loan notes.
The first high-yield IPO in Europe was the Nkr1.1 billion ($162 million) Findexa deal, which was also led by CIBC World Markets, as well as UBS and Goldman Sachs. Investors were sold common shares in a Jersey-registered holding company that capitalized the Norwegian operating company with a loan made from the IPO proceeds. The high yield of 11.5% is supported by both a dividend payout from the shares and the interest from the loan notes.