How do you fix the IPO market?
Trust has broken down between IPO vendors and issuers and traditional investors in new stock offerings in Europe. Deal arrangers seem incapable of bridging the valuation gap between the two sides. In bloody markets, hedge funds have been the buyers of last resort but some have wreaked havoc on the IPO process. The only thing all sides agree on is that something needs to change. Peter Lee reports.
IN THE FIRST seven months of this year, 143 initial public offerings were priced for European issuers, while 50 others, over one-third as many, were either announced and then postponed or launched and then pulled. That’s a very high failure rate by historical standards and comparable to the worst days of the financial system crisis that accompanied the collapse of Lehman Brothers in 2008. After the IPO market reopened late in 2009 it wasn’t meant to be this way. Worryingly, it’s even worse for larger deals of more than €350 million where as many transactions were withdrawn in the first six months of 2011 as were completed. And even of those larger deals that did limp across the finish line, more are now trading below issue price than above, meaning investors have lost money even on the so-called successes.
The biggest deal of the year in Europe, the €7 billion-equivalent IPO for commodities and mining firm Glencore, was trading at 9% below its May issue price when Euromoney went to press at the end of July.
"I don’t think Glencore got enough buy-in from mainstream institutional investors," says one banker. "It was well anchored by the cornerstones but I think if they had priced it just 5% cheaper they might have started with a more committed long-term share register and had a better trading performance in the first days and weeks. I’ve spoken to some highly respected money managers who tell me that after seeing it price at 530p, they won’t touch it for 12 months. And that deal now hangs over the market."
And there have been other disappointments. Betfair, an online betting exchange, priced its debut offering at £13 last October and its share price rose to £15.50 on the first trading day. As Euromoney went to press, the stock stood at £6.40, more than 50% down since issue. "You have to ask if that company should ever even have gone public," one long-only investor tells Euromoney.
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With large European IPOs suffering a 50% failure rate this year, an emotional debate has broken out over whether the fault lies with the highly uncertain macroeconomic backdrop in Europe or with a broken process for running initial equity offerings. It’s an important debate because a busted IPO market is a rotten sign of the fragile health of the European financial markets and economy. "IPOs typically do well in up markets when investors want to take some risk and put cash into new names and the implicit bargain with underwriters is that they will bring appropriate companies, some of which will outperform even if some underperform," says John Hyman, partner at hedge fund manager Cheyne Capital and a former ECM banker at Morgan Stanley.
He is worried by the collapse of the process in Europe. "IPOs are a significant source of growth capital for vibrant economies," he says. "They always have been in the US, and the Chinese, having seen that, are now adopting that model. But in Europe, there has been a complete breakdown of trust, partly because there are too many banks all trying to push the envelope on valuation without taking accountability for the quality of deals being brought."
Banks struggle to set initial price ranges
IPOs above/below/in range – 2011 YTD
Breakdown of trust amongst IPO vendors, issues and traditional investors
The investment banks that lead deals, issuers and their independent advisers and the institutional investors that buy them have been pointing to problems in the market and blaming each other.
In May, Luke Chappell and James Macpherson, managing directors at BlackRock, wrote a letter to the leading deal arrangers, expressing concern that issuers were appointing banks to lead deals on the basis of unrealistic valuations and using incentive fees to maximize issue price while BlackRock expects to buy stock in new companies at a discount. BlackRock, the largest institutional money manager in the world, even threatened that it would be "less constructive" on deals with large syndicates that it says do little to help the price-formation process.
"IPO candidates will have to start looking and behaving more like public companies before they are public companies"
"There has been a complete breakdown of trust between the buy side and IPO vendors," admits Craig Coben, head of European ECM at Bank of America Merrill Lynch, unconsciously echoing Hyman’s phrase. "And as a result of that, both issuers and investors are suffering as deals perform poorly and vendors look to venues outside Europe to list."
After some internal debate, BAML last month published a series of proposals – an apparent response to the BlackRock letter and agreeing with much of it – to overhaul the IPO process.
Its suggestions include arranging earlier meetings between company managements and potential investors in new stock; greater focus by companies on corporate governance structures; allowing for more independent pre-deal research including from non-syndicate banks; smaller syndicates or at least better management of larger syndicates as well as greater clarity over the role of independent advisers to issuers, particularly on their involvement in allocating stock to investors. BAML also asks for fuller disclosure and transparency on the metrics for allocating discretionary fees to banks and encourages greater integrity in more detailed feedback from investors, especially on valuation.
It all sounds a little obvious, and even slightly pious, and Coben admits that: "What we propose is not revolutionary." But, he adds, "90% of what we propose is not current market practice either. And while many of the difficulties facing IPOs recently have been down either to tough market conditions which none of us can control, or problems with particular issuers’ equity stories, there are also things we can all do to ameliorate the process. We can’t just carry on with business as usual."
It has indeed been a very tough market to issue into because of the sheer uncertainty around the economic and market consequences of the unfolding sovereign debt crisis in Europe. In mid-July, with the sellers pushing up Italian government bond yields, Deutsche Bank analysts suggested that if the eurozone crisis were to worsen, global stock markets might shed 35% of their value.
In the event, the initial market response to the second bailout deal for Greece announced at the end of July was positive. Yet investors are still lurching from risk-on days to risk-off days. And while markets in general remain vulnerable, IPOs are especially so. "I know from talking to many investors that it’s often a case of last in, first out," says one ECM banker.
Many suggestions have been made for improving the IPO process. All need to be considered in the light of structural changes in the secondary and primary equity market that, as well as the uncertain macro outlook, lie behind the recent failures of so many transactions and the flaws these failures reveal in the IPO process.
European IPO buyer base is in decline
The universe of potential buyers for European IPOs is now quite narrow and as well as declining it has also changed markedly from the great days of the big privatization IPOs in the 1990s and 2000s. Europe still lacks an equity culture. There is little retail buying of new equity. And new money is not flowing into conventional long-only funds. One ECM banker recalls working on a large equity placement for the restructuring of a household-name European industrial company. "I think [hedge fund manager] John Paulson took down more stock than the entire domestic institutional investor base," he says.
Because they are not being flooded with new allocations of money to invest in European equities, conventional institutional fund managers, who are generally paid to be fully invested, need to raise cash by selling out of existing holdings of listed companies if they are to buy IPOs.
And where there are any doubts about a company undertaking an IPO, either because it lacks an established track record of earnings, because its growth ambitions are untested, or because its balance sheet remains highly levered, conventional long-only investors will need a lot of convincing to sell stock in an established listed company that they know well. Investors might well have supported many of these public companies through rights issues to repair their balance sheets in 2008, 2009 or 2010 and might still consider them to be cheaply priced.
BlackRock emphasizes the point: "We expect to value companies seeking to float at a discount to such a peer group to reflect the lack of a public trading record, not least because any new idea has to compete for capital with our existing holdings."
And there is a particular resistance among many UK-based conventional long-only fund managers to supporting IPOs of companies from private equity vendors. These have accounted for almost one-third of the deals attempted in Europe this year, a higher percentage than normal, when they might account for 15% or so.
Investors lose out as European deals trade down
Aftermarket performance - 2011ytd
Alasdair Warren, European head of ECM at Goldman Sachs, says: "Companies like New Look [the UK fashion retailer owned by Apax and Permira which postponed its IPO last year and has ruled out a return this year], and Travelport [the Blackstone owned company that also postponed its London listing last year] aren’t bad companies but they were significantly more levered than their peers when they attempted their IPOs. In cyclical sectors and in difficult market conditions, investors clearly feel that represents too much risk. Yet there have been sponsor-owned and leveraged companies, like Amadeus, KDG and AZ Electronics Materials that IPO’d in the last year or so, have performed well and have turned into market darlings. Investors seem to forget those."
One source at a conventional long-only fund manager says: "Having stumped up a lot of cash for rights issues to support companies we already own, it’s not so attractive to stump up cash to support companies for the benefit of other controlling shareholders." He suggests that if private equity vendors want to use IPO proceeds to de-lever portfolio companies’ balance sheets, they should feel free to inject equity themselves before selling those companies onto the public market.
Choosing the right candidates
It would seem sensible, with markets so jittery and investors so hard to convince, for vendors and lead banks to be highly judicious over which companies to bring to market. But they might not be picking the right candidates to list in these tough conditions.
"Due diligence is not taken as seriously as it once was in the days when the responsible partner at a Cazenove or a Warburg would have to vigorously debate the case with other partners for the firm to sponsor a new issuer," says one ECM veteran. "Investment banks are much less fussy now about the gatekeeper role and so you see some companies that are ill prepared for public ownership or that do not have a sufficiently differentiated equity story. When these fail it’s always blamed on volatile market conditions, but some of them should not even have been attempted in the first place."
Vendors are often running dual-track disposal strategies, looking to sell companies either through M&A deals with trade buyers, through secondary sales to other private equity bidders, or, in the absence of any interest from those buyers, through listing on the public markets. Some companies that come to IPO only do so via negative selection, because no corporate or sponsor will pick them up.
It’s not just that vendors and banks are backing the wrong companies to list. They are also trying to sell in a nervous market as if it were a bull market.
The conventional long-only manager adds: "Now it is in everyone’s interest including ours to have a thriving market where deals are being completed and succeeding. But when you see a €500 million deal for a €1 billion company where the proceeds are to invest in business expansion and you are asked to value those future earnings streams as if they already have been secured, I’m sorry but that’s just not the way it works."
He says: "The price formation process isn’t working at any stage of the process, from inflated and unrealistic expectations at the outset, to first meetings when we’re trying to understand the company but being pressed from many quarters to come up with precise valuations against a peer group, all the way to the end of the process when some investors are still offering no guidance on valuation and just putting in orders at the strike price."
With conventional institutional investors unimpressed by many of the companies being brought to the market and put off by the process of being pressed to buy at unrealistic valuations, that leaves one large remaining group of investors as the last resort for many IPO vendors: hedge funds.
Hedge funds play a bigger role in the IPO process
Hedge funds, which 10 years ago played only a marginal role in the IPO process, accounting for, say, 5% of any order book, can often now account for more than half the book, sometimes 70% or higher. And while some hedge funds might count as well-informed and valuable accounts, there are many that are less desirable to have on the share register of a newly listed stock on its market debut.
Almost by definition, many hedge funds that go long a stock through an IPO allocation will also have a short position, perhaps in the stock of a comparable company that is already listed. So their participation will tend to drive down the share price of the peer group companies against which conventional investors will seek to value new entrants to the public listings. Many hedge funds will pursue technical trading strategies and seek to unwind linked positions, so flipping out of the new stock fairly soon after launch.
"Investors are so used to getting book updates that many will not place orders until they have heard that a deal is covered"
Some bankers are keen to find ways to address this problem and hope changes to the IPO process might help bring it about. Sam Dean, co-head of equity capital markets at Barclays Capital, says that the way lead banks now communicate to the wider market how well the book for an IPO is covered in the days leading up to pricing must be looked at. He says: "The problem with ‘book updates’ is that they only address quantity not quality which, of the two, is the far more important factor. Investors, however, are now so used to getting these updates that many will not place orders until they have heard that a deal is covered. In a market where investors are leaving placing their orders until the last minute, this is creating a self-fulfilling prophecy of failure. Also, these updates are attracting low-quality investors which is sometimes why deals trade badly in the immediate aftermarket. Some will say that I am arguing for less transparency but the point is that I am arguing to somehow limit comments which can be misleading because of the lack of context."
Dean suggests that the bookbuilding process plays into the hands of low-quality accounts. These will often send an email immediately after launch requesting a big allocation of stock at the so-called strike price – in other words at whatever level the deal is priced by others, rather than with varying levels of demand at different price points, which is much more useful information for ECM bankers and issuers. Such large, early orders at the strike price can, of course, be pulled at the 11th hour, leaving a seemingly well-subscribed deal under-subscribed with days or hours to go until pricing. Investors place the orders in case a deal goes well, in the hope of getting a big allocation. And if the deal goes poorly they will sell their allocation out immediately while the bookrunners are still stabilizing the price, trying to hold it steady in the first hours and days of trading. In other words, the process gives these investors a free option.
Why would anyone do a deal when it depends on such low-quality orders? Only for one reason: because there are no other buyers. A veteran banker at another firm says: "I have done deals when I’ve had to go to the issuer and say, ‘look you are covered to do this, but the turnover will be immense after launch and the price will probably fall’. And you get issuers that say, ‘well, I need the money to grow my business, so if it’s either that or no deal at all, let’s go ahead’."
The losers here are any few remaining good-quality accounts, investors that have researched the company, taken a positive view on it at the debut pricing level and are prepared to own it for some time, but who see it immediately sink. There are any number of IPOs this year that are now 20% to 40% below issue price.
One banker says: "I’m not sure that the higher-quality institutions realize that when they are being told that a deal is covered, it may well only be covered with this sort of demand. Why else is it that so many deals are trading badly almost immediately? Someone must be selling!"
If book updates are one of the tools that those lower-quality accounts rely on to play their game rethinking the use of those updates may be useful in limiting their unhelpful behaviour.
The problem with book updates
There’s another reason that other bankers raise for abandoning book updates. There have been so many poorly performing IPOs recently that even the low-quality investors are losing interest and there are often no firm orders from anywhere until just before pricing.
It’s worth asking, though, why banks can’t do a better job of getting more good-quality accounts into deal order books. Is it because conventional buy-and-hold investors are on strike? Ones that Euromoney talks to say they are not. Rather, they are simply cautious on valuation. Is it because sentiment is so poor and recent experience so bad that they are very reluctant to participate? Perhaps. But there might be another explanation.
The leading investment banks are much more heavily dependent now than they once were on trading volumes from large hedge fund customers. Dealing margins are thin and the key to trading earnings is volume. That’s what hedge funds offer.
Almost as many European deals pulled as completed
Global IPO market activity
When a trader leaves an investment bank and sets up a hedge fund, that trader will often seek all manner of prime brokerage services from an investment bank as well as funding and even investment in funds, all of which the investment bank will provide partly in return for trading volume.
If the hedge fund grows it can become a very important customer. Consider a long-only fund manager with €100 billion under management that turns over 15% of its portfolio in a year. That long-only fund is a much less important account to an investment bank than a smaller hedge fund manager with €20 billion of customer funds, if those funds are then three times levered and the total is then turned over 10 or 20 times a year.
The result is that investment banks today are geared to serving an investor customer base large parts of which are not ideal buyers of IPOs.
Is there a way around this for issuers? Potentially, yes, but it is one fraught with difficulty. Say that an issuer or vendor accepts that the leading global investment banks that are the natural arrangers of any equity deal are all set up to talk first to the same 150 global investors, be they conventional long-only funds or hedge funds. One way to get the benefit of distribution to smaller institutions that the global investment banks no longer cover is to bring in co-lead managers with closer relationships to regional- and national-scale institutions. That means a larger syndicate and one that has to be managed carefully.
Ludicrous bookrunner groups
The global investment banks will argue that there is no corner of demand that they do not cover. It’s a claim issuers would be well advised to treat with caution. The case for large syndicates of different banks, each capable of adding incremental demand, is being obscured by another worrying and ludicrous trend towards ever larger groups of joint bookrunners, with six or more supposedly running a deal rather than two or three.
The lead banks are also increasingly arguing against the move to large groups of bookrunners appointed by vendors and issuers keen to repay lending banks with equity league table credit. In a highly competitive marketplace where bankers’ jobs are on the line and they are desperate to book business, some banks are telling issuers that they won’t come into deals in lesser roles. It’s an idiotic process. Banks aren’t going to get a boost in the league tables if they’re all being named bookrunner. In the US market, there are now so-called passive and active bookrunners to distinguish those with a lead role in name only.
For issuers, the danger, especially in tough markets, is that no one or two banks take responsibility and ownership for dragging the deal across the finish line. "I’d much rather work on deals with just two or three bookrunners, especially when markets are difficult," says Warren at Goldman Sachs. "We have worked on some very big deals where there were certain key decisions that were really quite obvious but which it required a very long time to take because there had to be some kind of consensus. You don’t run big difficult deals in tough markets by consensus. And when you try to, I’m afraid that leaves too little time for the most important job of targeting and attracting the best investors to establish the best share register.
"If investors are getting called by eight so-called bookrunners they’ll tend to give very generic feedback rather than the more subtle and nuanced insights, especially around valuation, that is much more valuable when you have to exercise key deal judgments."
The problem is probably being compounded by the way banks are now paid fees on equity deals.
In the early days of the European equity capital markets in the 1990s and 2000s, banks were guaranteed a portion of their fees as a flat payment for working on the deal and allowed to compete for a bigger slice of the economics on the basis of bringing orders into the book. This led to plenty of internal conflict as syndicate members wrangled over who really deserved credit for bringing Fidelity, or Schroders or BlackRock into the deal. Even inside banks there was conflict over whether credit should attach to the salesman in Boston or the analyst in London.
The leading banks, the regular global coordinators, pressured investors to designate orders to them in good markets when demand exceeded supply. The implicit threat to investors was that they would not be so well treated on stock allocation in hot deals if they insisted on putting orders through junior syndicate members. So that so-called jump-ball system broke down.
Now orders all get placed into one central pot and there is much less wrangling for order designation and sales credits. A large portion of banks’ fees is paid at the discretion of issuers according to sometimes ill-defined metrics of their overall contribution to the deal process.
Concerns grow over fee incentives
Some investors fear that incentives are all based on maximizing issue price to the benefit of vendors and issuers and contrary to the interests of IPO buyers. BlackRock was speaking for many when it wrote to the banks that: "We are concerned about the structure of incentive fees which maximize your returns for the price achieved on the first day of trading rather than at some, more distant date, eg, six months after float. Such fees do not represent an alignment of interests between us and seem to drive increasingly aggressive behaviour from syndicates."
Banks themselves say this misses the true problem. They say they do want to set a fair price for a deal and that only a small handful of vendors and issuers gear compensation to maximizing issue price. Rather, the banks say the bigger problem with discretionary fees is that they encourage group think among large teams of bookrunners and discourage any banks from being the bringer of bad news to an issuer for fear of being cast as not a team player and so an undeserving recipient of a discretionary fee.
One banker says: "There are times when you might have to bring a really tough message, such as that the business is too highly geared or even ‘I know you really rate your CFO, but the market view is that this person is not up to that role at a public company’. In large bookrunner groups, issuers will always find one or two banks that will say they have no problem with the CFO. So the tough message doesn’t get absorbed and, after a while, you decide it’s better just to keep your head down."
One way to improve fee incentives might be to tie the payment of discretionary fees more closely to banks delivering the outcome that they originally promised when pitching for the business. To the extent that global coordinators promise to deliver a stable share register of committed long-term owners with decent price action and low volatility and turnover after a deal is complete, perhaps a greater portion of their fees should be withheld until some time after the stock starts trading.
Investment banks, of course, have always baited and switched, promised issuers the world and blamed deteriorating market conditions when they could not deliver. There should be no harm, however, in holding their feet a little closer to the fire. Sure, markets can deteriorate between winning a mandate and executing a deal, but some portion of fees could be paid based on share price performance, volatility and turnover relative to an index or other benchmark of relevant peers.
Engaging early with investors
For all the disagreements and competing vested interests, all sides seem to be moving towards agreement on a few issues.
One is that the IPO process would work better if potential investors had an early opportunity to meet the managements of potential IPO candidates, so that investors could get a measure of managements, gauge their business plans against future delivery, understand the company fundamentals and start to model against publicly quoted peers.
"It’s a suggestion we’ve often made to managements and vendors in the past and we’ve met resistance sometimes because boards and even executive management teams are still being cobbled together rather late in the day. But I think IPO candidates will have to start looking and behaving more like public companies before they are public companies," says Coben at BAML. "And if we’re going to build deals around cornerstone investors more in Europe so as to de-risk the process, then you’re not going to get that order to own 10% of the company on the basis of a one-hour meeting 10 days before pricing."
Charlie Foreman, head of ECM advisory at Lazard, sees the way the wind is blowing. "Gone are the days when a one-hour meeting culminated in a €100 million order. We fully subscribe to the view that companies that intend to go public should engage early with investors and we think that even with a deal not imminent, pubic market investors would be happy to meet large private companies in sectors they’re invested in."
Earlier meetings between IPO candidate companies and potential investors might help resolve another sticking point in the IPO process: the cumbersome process of presenting pre-deal research.
In Europe there is much agonizing over how useful are presentations of large books of pre-deal research by syndicate banks and also over whether issuers have become too keen to silence dissenting opinions by getting all banks with the key sector analysts into their syndicates and by withholding company presentations from analysts at banks outside the syndicates.
The whole issue is a muddle. Some smaller institutions might well depend on bank research. Most big ones and the price-drivers probably pay less attention to it whether it comes from syndicate banks that will probably be fans of the company or non-syndicate banks that might have their own axe to grind.
It’s worth noting that there is no pre-deal research in the US. Deal timetables tend to be shorter than in Europe and the deal prospectus is posted early, typically a couple of weeks before pricing. Retail investors take decisions based on its contents and institutions use the prospectus for their modelling against comparables.
"An IPO is already a complex process. Let’s look for ways to simplify it, rather than further over-engineer it," says one banker.
Overcoming investor resistance
Several banks suggest that one way around the general resistance of public investors to IPOs out of private equity portfolios is for vendors in Europe to do smaller initial IPO issues, priced at a discount to compensate for initial illiquidity and the remaining overhang of unsold stock, but, it’s to be hoped, leading to good after-market performance and creating a more virtuous circle.
Tim Harvey-Samuel, head of Emea equity capital markets at Citigroup, is a keen advocate of this way of making the IPO of a private equity portfolio company less of a cashing-out event and more the first step in a multi-year engagement with the public market.
"That’s the way it tends to work in the US and it works fairly well," Harvey-Samuel says. "There’s no reason why European private equity and other vendors shouldn’t take the same approach. It would require a lifting of the minimum free float requirement on the London and certain other exchanges for an initial 25% of market cap but this can and should be discussed. Vendors may feel pressure to make large initial cash realizations, but by changing their approach they can execute sizeable subsequent monetizations that improve their overall price and benefit investors."
Smaller initial placements of stock would also preclude IPOs of excessively levered sponsor-owned companies, which typically require a large fixed amount of cash to be raised simply to restructure the balance sheet.
There’s a lot of thought being put into all this. The biggest danger for the market is that so few deals get done in the next six months that all this gets lost and when and if overall sentiment improves and the market revives, it all gets forgotten and the same problems continue to fester.