The return of IPOs

FOLLOWING THREE LEAN years, equity capital markets bankers today find it hard not to smile as they predict a massive increase in new equity issuance this year. The robust primary market recovery began in the fourth quarter of 2003. It looks set to continue. "Total issuance can only be higher than last year," says a European head of ECM. No-one doubts that. But the estimates for just how much higher vary between 15% and 50% in Europe.

The confirmed backlog for US issuers at the end of 2003 already showed 77 deals in the pipeline, expected to raise $12 billion, compared with 32 deals worth $4.4 billion at the end of 2002. In Europe the value expected from privatizations alone should top 2003's total IPO volume.

China's privatization programme, estimated to be worth $11 billion in 2004, is equivalent to nearly half the total IPO volume from Asia last year, when the region's $24.9 billion-worth of IPOs was greater than the rest of the world's combined. The numbers are certainly encouraging.

Volume won't be the only thing that changes in 2004. The business mix will alter too, with rights issues making way for a return of the IPO market. Convertibles volume, which accounted for 43% of ECM issuance in 2003, is expected to remain strong but to account for a smaller proportion of the growing business as IPOs and secondary share sales grab bigger shares.

According to Joe Manko, Deutsche Bank's European syndicate head, the reinvigorated IPO market is being driven by several key factors. "The first is private equity," he says. "The IPOs this year will mainly come from financial sponsors taking the opportunity to finally make their exits. The second is the return of M&A activity. Stock deals are not as prominent as before so companies will look to raise cash through selling non-core holdings through block trades. Companies are returning to focus on their core businesses and so there will be a number of spin-offs and IPOs of non-core businesses. Privatizations, especially in Europe and China, will be another important source of IPOs."

The leading banks are raring to go. "Every bank has a good 10 or so candidates ready for an IPO in their pipeline across sectors and across regions," says Flavio Valeri, co-head of corporates at Merrill Lynch's capital markets and financing group. "Or at least we do," he says. "The only question now is timing."

If IPO volume increases as much as predicted, many firms, especially US investment banks that zealously culled ECM bankers during the bear market, could be stretched. IPOs require a lot more work and take a lot more time than deals such as block trades of liquid stocks and convertibles. Already several firms are recruiting.

And bankers are debating how all these deals will be done and the prospects for a return to the days when they earned big fees for little or no underwriting risk.

"The fully marketed IPO and bookbuild was introduced as a way of creating competitive tension into an IPO," says Philip Shelley, an ECM executive director at UBS. "Historically, one would talk to a relatively small group of investors and establish a price ahead of announcing the transaction. The danger with that process is that it potentially gives away pricing power."

Block trades (2003) After-market performance (%)

Source: Market sources

The fully bought overnight deals that now characterize the block-trade business have helped raise the expectations of issuers for more aggressive pricing and this is driving a trend towards faster IPOs, as epitomized by last year's landmark £389 million ($708 million) IPO for Northumbrian Water in the UK. In that transaction, broker Collins Stewart and Deutsche Bank bought the utility in an auction bid funded by pre-placing shares with institutional investors, allowing the company to be floated on junior London market AIM simultaneously. This has become a model for other transactions, such as leisure parks group Center Parcs, which floated last December

For such an approach to work, the company must be an easy sell because the broker has to be able rapidly to pre-place the shares and bid in the auction. Companies in defensive sectors with simple structures and highly predictable businesses are therefore the most suitable candidates. There may be several more such deals this year.

According to ECM bankers there is no way to shorten the traditional IPO process for most companies. "The way blocks are done nowadays is essentially price check, volume check, and off we go," confesses a global head of ECM syndicate. "The block business is ultimately a trading decision. With an IPO, though, there is a lot more real work to be done," he says. "You're building an investment case for the first time. It is impossible to do a one-day show for a completely new company's IPO where the management is unknown to investors, because investors need time to take a fundamental view on the company."

IPOs might appear to run to shorter timetables as bankers and issuers keep their cards close to their chests for longer. "The visible part of it may get shorter as transactions are officially launched later, but all the work done beforehand will be the same," says the head of syndicate.

Last July's £1.2 billion IPO for UK directories business Yell, led by Goldman Sachs and Merrill Lynch, illustrates the point. That deal appeared to be completed very rapidly, with only two days of bookbuilding. But such a shortened timeframe would not have been possible had it not been the company's second attempt at an IPO in 13 months. Investors had already sat through the presentations once before.

"Investors are incredibly discerning," says Alasdair Warren, managing director of European equity capital markets at Citigroup, "in order to make investment decisions they need to meet management. You can facilitate that in a relatively low-key way with a limited group of "core" investors through so called pre-soundings, as was done with Yell [the second time], or in a more public way like the IPOs we saw in 1999-2000. It tends towards the latter as confidence increases," he says.