Direct listings: the future according to Goldman Sachs

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By:
Mark Baker
Published on:

A new approach to going public has so far been tested by only two firms, but the people who did those deals see them as the start of something bigger.

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A trader passes by screens showing Spotify on the floor at the New York Stock Exchange


This may be a big call after only two deals, but direct listings could be the hot topic in equity capital markets in 2020. Some of those closest to the newly emerging technique reckon there will be at least five next year. But the number is not the point.

Much more important is the way in which direct listings are set to reshape how a new generation of bigger private companies accesses public capital markets – and the ways in which such deals might even change the traditional IPO.

Regulators at the SEC have already proved themselves flexible when it came to the first deals. Bankers hope that they might now be poised to take the biggest step of all and pave the way for deals that include the raising of primary capital.

One of next year's direct listing candidates could be short-term property rental company Airbnb, which has been talked about as the most obvious prospect for the technique since messaging company Slack completed its direct listing in June.

Goldman Sachs and Morgan Stanley, who worked on Slack and on the first direct listing, a deal for music streaming company Spotify in 2018, are widely rumoured to be mandated on Airbnb.


If your business needs cash, just think opportunistically about where your lowest cost of capital is, go get it when the window opens 
 - Barry McCarthy, Spotify

The two banks are doubtless hoping that their work on the new listing format can help mitigate the embarrassment of their involvement in traditional IPOs for names like Uber (for Goldman and Morgan Stanley) and WeWork (for Goldman).

Morgan Stanley is set to hold an event later this month to discuss direct listings, while Goldman hosted a discussion at its Private Innovative Company Conference in early October in Las Vegas, where it brought 500 investors to meet emerging technology companies.

Goldman certainly has pedigree to protect when it comes to IPOs.

It was at Goldman in the 1980s that Eric Dobkin – the firm's longest-serving partner when he finally left in 2016 after 49 years – drove the development of many of the techniques that are now taken for granted in flotations.

But if the firm didn't precisely invent the IPO, it certainly wants to be seen as reinventing it.

Public vs private

Will Connolly, head of technology ECM at Goldman, reminded the conference audience that the needs of many companies had changed in line with their ability to grow much faster in the private markets than was possible before.

"You have businesses with the benefit of technology that have built to scale much more quickly than they could have in the past, and you've also had several companies that have made the choice to raise a significantly greater amount of capital in the private markets than they would have ever done before," he said.

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Barry McCarthy,
Spotify

There are few more striking illustrations of how much and how quickly this has changed than the story that Barry McCarthy tells of his experiences taking Netflix public in 2002 and then Spotify, where he is CFO, in 2018.

In the year before Netflix went public, the company had about $71 million of annual revenue, $13 million of net cash and 600,000 subscribers. Spotify went public with $4.2 billion of revenue, $1.7 billion of net cash and 71 million subscribers.

"I realised that it was one of those 'Dorothy, we're not in Kansas anymore' moments," McCarthy told the audience at the Goldman event.

Just a week after the conference, however, Goldman chief executive David Solomon appeared to be dampening expectations that this trend would continue completely unabated when he presented decidedly mixed third-quarter earnings to analysts on October 15.

The bank disclosed a $267 million net loss for the $2.3 billion public equities portfolio that it holds in its investing and lending division. Most of that loss was attributed to its holdings in Uber, Tradeweb and Avantor, which together make up about 40% of the portfolio.

But it also disclosed that it was taking a $80 million mark against its investment in WeWork, a company that remains unwillingly private and so is buried in Goldman's $19.7 billion private portfolio. The bank's holding is now marked at $70 million, although it noted that this continues to be above the position's embedded cost.

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David Solomon,
Goldman Sachs

“I do think that we are going to see a rebalancing of this process of private capital formation, the size of it and the period of time that people take to get to the public markets," Solomon told analysts.

Solomon also gave short shrift to the possibility of banks losing out meaningfully from the direct listing process.

"I think the noise around this really disrupting the IPO market or potentially disrupting the economic opportunity for the leading banks in the IPO market is overstated at this point," he said. 

"But I do think that there will continue to be evolution in these processes and if there are ways that we can serve clients better or get them to market more efficiently, then we're certainly willing to do that."


How quickly that happens remains to be seen. But right now equity capital markets are suffering from something of a crisis of confidence in the wake of poor performances of names such as Lyft and Uber, and the collapse of the IPO prospects of WeWork as it became clear that investors would not accept the most recent elevated private-market valuations for the company nor the somewhat startling indulgences of its co-founder Adam Neumann, who has since stepped down as chief executive.

That said, for all the criticism of the WeWork situation, it remains the case that the public market ultimately shunned the company, showing that many investors have not entirely forgotten proper scrutiny, even if some lenders appear to have done so.

'Chronically broken'

For his part, McCarthy thinks the public market has been "chronically broken" for some time, hence his desire for Spotify to have "an IPO without the O".

He did not want to sell 15% of the company's market cap at a discount simply to secure a secondary market for the stock. He did not want anyone to be subject to a lock-up, which he says would have violated a core principle for him: after all, Spotify had more than 2,000 private shareholders.

And he didn't want many of the other shenanigans that surround a traditional IPO either, such as hedge funds shorting the stock into the lock-up expiry, or the artificial management of demand and supply that is part of market stabilization.

"It's just all bullshit," he noted.

A company using a direct listing cannot choose its initial shareholders, of course, but to McCarthy's mind this is of little consequence given that high-quality long-term shareholders no longer have the kind of influence they once had on a company's stock price, precisely because they are long-term holders.

"They don't participate in the price-setting mechanism," he said. "They're sitting out the dance."

And that dance is increasingly played out between high-frequency trading systems.

This is something that McCarthy saw at Netflix, where between 2002 and his departure in 2010, the average trade size fell sharply, even as total trading volume increased a lot.

"Go spend time with the big guys," added McCarthy. "But don't do it because you think it will help your stock price. It won't."

It’s an example of how he sees things from first principles, but there are others. At its heart, an IPO is just a financing event, he said, but a pretty expensive one.

"If your business needs cash, just think opportunistically about where your lowest cost of capital is, go get it when the window opens," he added. "Then you can think more creatively about your going-public event than you would if you were cash-strapped."

He didn't reference WeWork, but he could have done. WeWork's IPO was infamously a strict condition of any further lending. Now the IPO is off the agenda, the company is scrabbling around for new funding.

If it gets it, it will be very expensive.

Changes

Market participants were excited when Slack followed Spotify in using a direct listing in June.

Success is a trickier thing to measure in direct listings than in traditional IPOs: that the stock is now down 36% from its first day while the S&P is roughly flat over the same period does not carry quite the same stigma as a traditionally under-priced IPO trading off by the same degree. There was, after all, no bookbuild and no setting of a formal offer price.

But even at the time many also cautioned that the process was likely to be one that would not be suitable for all comers. Successful candidates would be those that already had a widely known brand, such as Spotify and Slack. Airbnb falls into that category too.

They would also, it was said, need to be in a position not to require capital raising at the time of going public.

Things are changing. First, traditional IPOs could actually learn from the direct listing process, McCarthy argues. You could, like Spotify was permitted to do, give guidance and host a full-blown investor day.

The reverse could also happen, with direct listings learning more from traditional processes. Spotify chose to do without a roadshow and the traditional analyst activity.

"But you could incorporate that, particularly in a business that was harder to understand than Spotify," said Greg Rodgers at Latham & Watkins, also on the Goldman panel discussion. He was counsel to Spotify for that firm's listing, and counsel to Goldman on the listing of Slack.

Spotify's McCarthy thinks that not bringing analysts over the wall is actually a good thing, albeit one that makes you very reliant on others to tell your story, though after Spotify involved the whole analyst community in its investor day, there was a wealth of published research.

"Suddenly you had this enormous echo chamber that was educating the world of institutional investors about how the business model worked," McCarthy said. "That doesn't exist in the traditional process."


The SEC’s mandate is to have as many public companies as possible. They recognize that the inability to raise primary capital is a limiter. So, in the long term, I like our chances there 
 - Greg Rodgers, Latham & Watkins

Second, and most intriguingly, regulators might be willing in the future to allow simultaneous capital raising alongside the listing.

Rodgers reckons this could happen.

"The SEC’s mandate is to have as many public companies as possible," he said. "And I think they do recognize that the inability to raise primary capital is a limiter. So, I think in the long term, I like our chances there."

That's partly also because the SEC's management is seen as deal-friendly. Chairman Jay Clayton was a corporate finance lawyer at Sullivan & Cromwell, while Bill Hinman, who heads the SEC's division of corporation finance, was also a corporate finance lawyer at the Silicon Valley practice of Simpson Thacher & Bartlett.

But squaring innovative thinking around deal structures with the SEC's mandate to protect small investors inevitably adds challenges. Pre-deal work on Spotify took about a year, said Rodgers, compared with perhaps six months for a traditional process.

That said, it's still possible to raise capital before or after a direct listing, or alternatively an issuer could do a 144a convertible bond once public.

"And then a year later, you are a seasoned issuer and you can do any form of short-form registration you like," added Rodgers.

What's critical, according to Goldman's Connolly, is exploring all options.

"Doing something because someone else did is the best way to get to a bad solution for you," he said.

Banks still needed

Euromoney has previously reported on how the notion that a direct listing disintermediates investment banking advisers is misplaced. It suits banks to argue that their role remains important, but for the moment it also happens to be true.

Connolly argues that a bank's role advising on a direct listing is not that different to on a traditional IPO. It is advising the company on positioning, on metrics and guidance strategy, on which investors to educate, and on how to present advice on an analyst day.

It can't take the company on a roadshow, since that would constitute underwriting work, he adds. But the banks can still go on their own roadshows, seeing buyers and sellers, and making sure both sides are sufficiently well-informed to help create a liquid market on listing day.

And while a deal count of two so far might hardly constitute evidence of a trend, Connolly noted that even between the first and the second there was a clear shift in the behaviour of investors.

"Investors who talked to us after Spotify’s direct listing said: 'That was a difficult process for us; we don’t know how to get our arms around it, we didn't feel comfortable participating in it'," said Connolly. "Some of those investors actually were some of the most active participants in Slack’s direct listing."

And over time investors would get even better at dealing with this new animal.

"Right now, they have an ‘n’ of two," he added. "That n is going to grow, and the market's going to learn."