Capital-raising in direct listings: wait, what?

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By:
Mark Baker
Published on:

Could the direct listing format withstand an injection of primary capital-raising? Yes, but not without complications.

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The news that the New York Stock Exchange (NYSE) is mulling ways in which capital raising might be added into the direct listing toolkit has sparked a lively discussion among market participants as to the merits – and practicalities – of such a move.

It is a topic that had already been raised by direct listing pioneer lawyer Greg Rodgers of Latham & Watkins in a Goldman Sachs-hosted panel session on the subject back in October, but the concept has taken a step forward with the publication of NYSE proposals on the topic on November 26.

It is early days for the direct-listing method of going public – so far there have only been two such deals, for Spotify in 2018 and Slack in 2019. But as things stand, the format probably has three drawbacks compared with a traditional IPO: it can't raise primary capital; it needs a fairly robust private shareholder base that is about to become the entire market in the company; and it arguably requires a high-profile brand that can market itself to investors in the absence of the full-blown publicity effort that accompanies a mainstream flotation.

The attraction of adding a primary capital element to a direct listing is that it tackles the first two of those three issues, with the capital sold ideally forming the basis of the free-float trading pool.

Discussions have already been held between market participants and the Division of Corporate Finance at the Securities and Exchanges Commission (SEC) on the possibility of bolting capital-raising onto the direct-listing process. More meetings are scheduled in the new year.

Separately, the NYSE has been pressing ahead with its own thoughts on the process. Rival Nasdaq has reportedly responded with the deliciously catty comment that the NYSE's ideas did not fully consider "the complexities of the issue", but it is understood to be considering something similar soon.

NYSE has hosted both of the direct listings to have happened so far, but both venues will know that they need to stay on top of what might be an emerging trend.

After all, exchange rules can take quite a while to adapt. The talk in the market is that it took over a year for NYSE to get comfortable with allowing the Spotify trade.

Right or wrong?

Can it work for everyone? The reality is that there will be companies that will value the certainty that an underwritten process can bring, as well as the marketing and investor-education effort that can be deployed by financial advisers.

But not every company will need that, and it is for that reason that some in the market dislike the characterization of the direct listing as something that will somehow threaten traditional IPO business.

That might be part of the reason why Goldman’s chief executive David Solomon was recently quick to deflect any talk of direct listings eating into Wall Street IPO fees – the other might be that direct listings can also be lucrative.

The direct listing, some argue, should be seen as merely part of the toolkit, not something that stands in the way of the usual approach.

The simplicity of its business model is what made Spotify a prime candidate for a direct listing. After all, at heart the streaming service is only users multiplied by subscriptions minus licensing fees. And the product itself – music – is one that is well understood.

That is a rather different prospect to, say, a pioneering biotech with a complicated and risky investment case and for which the core buy side might be no more than 30 specialist funds. That kind of name would be an ideal candidate for a traditional IPO, where investors can take confidence from the involvement of big investment banks.

While direct listings do share some of the characteristics of a traditional IPO, the biggest difference is probably the price discovery mechanism, with no formal order book used by bankers to gauge a market-clearing price that strikes the best balance between the demands of issuer, selling shareholders and the buy side.

Instead there is a process managed by a direct listing's designated market-maker whereby selling and buying interest is collated to arrive at an opening trade on the day of listing.

It remains still to be seen how a primary element would be bolted onto a direct listing, but the working assumption for the moment is that the company would sell new shares through the opening trade and at that same price.

You say tomato

There is an obvious question that arises if direct listings evolve to appear more like traditional IPOs, with the additional complexity that this would inevitably bring. Why choose one over the other when they get more difficult to tell apart?

It will probably always come down to the price discovery. Issuers that tick the boxes and are able to consider a direct listing would probably do well to do so. The traditional IPO, while suitable for many listing candidates for the reasons outlined above, is still – in the opinion of many – a problematic process.

It is, they say, a fundamentally flawed system of driving price discovery. Banks introduce issuers to a group of potential buyers over a two-week roadshow, but the truth is that this often this may not arrive at the best outcome.

As one market participant puts it: "None of those funds has any incentive to communicate their best and final price – why should they? They are just bidding against themselves."

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The New York Stock Exchange is leading the direct listing charge

More to the point, in the tug of war between issuer and investor, where will a bank's loyalties lie? With the company that is listing or the buy-side accounts with whom the bank transacts every day?

That could be the attraction of conducting the price discovery process on the floor of an exchange. It is what market professionals like to call a two-sided blind marketplace, with more transparency and less of the secret sauce that equity capital markets bankers would claim is their added value.

After all, any smart computer – helped by an overlay of human input from advisers and a direct listing's designated market-maker – can generate supply and demand curves and identify where the two cross to arrive at an optimal clearing price for a direct listing's opening trade.

And for the buy side, it is a more transparent process. If they have conviction, they can put in an order at what they know is a market price, but they can also correct that position in real-time, compared with the cumbersome process of placing and amending orders in a bookbuild when the outcome is largely unknown until the last moment.

Is there a downside? The lack of certainty is the most obvious: practitioners fret that as direct listings grow in number, as they are expected to do, some firm some day is going to announce plans to be a public company via that method, and then end up with a valuation that is unappealing. The addition of capital raising to the direct-listing process would only make this more of an issue.

In a traditional IPO, with a soft sounding of the market ahead of any formal bookbuild, that would be often be dealt with at an earlier stage of the process. In a direct listing, it will be much closer to the moment of going public. Pulling the operation at that point will incur an embarrassing reputational hit.

And it can sometimes be hard to figure out whether a direct listing is going to end up being something that liberates issuers from the inconveniences of the traditional process, or something that adds its own, different difficulties.

Lock-ups are a good example. Promoters of direct listings argue that the lack of lock-ups could be a benefit, but some involved in discussions around potential deals note that there are listing candidates that worry about uncontrolled mass selling. That is why there is already talk of using the direct-listing format for the pricing mechanism, but still imposing lock-ups in the traditional way on certain existing shareholders.

Winners and losers

Part of the reason that any company can even consider a direct listing is the size that it is now possible to reach in the private arena.

Funky tech companies routinely no longer view the public markets as the natural place to seek growth capital – unsurprisingly, when they can secure many multiple rounds of private funding, a process in which traditional public investors are increasingly getting involved.

The other driver is the lack of regulatory scrutiny when private. The SEC – as with other public market authorities – is a strange animal in the regulatory arena. If you are a US drug company, you are stuck with the Food and Drug Administration (FDA), whether you are public or not. But companies going public voluntarily submit themselves to SEC rules.

Many now wonder why they should do so. In the most recent International Institute of Finance (IIF) meetings, JPMorgan chief executive Jamie Dimon and his Morgan Stanley counterpart, James Gorman, both despaired at the burdens that being public imposes, with Dimon quipping that he would take his bank private if he could and Gorman lamenting the pain of shareholder meetings.

All of which means that gone are the days when an Apple or a Salesforce would go public with much of their growth still to come. But for that reason, there is plenty of discussion now of the potential for quasi-public forums in which early-round private investors might more easily liquidate their holdings in the absence of an IPO.

The typical Silicon Valley firm will have rights on all its shares, with perhaps an opportunity for investors to offload them once a year. Spotify, a Swedish company, was a little unusual in this respect, taking what those close to it say is a rather Swedish tradition of letting holders largely do what they wanted with its stock.

But could a direct listing be a neat way for a large investor in other big private companies to create a public market for a privately held stock?

Not so fast, says one expert. For one reason, the way things are currently constructed, a listing is inherently connected with the company itself. It is responsible for adhering to the registration requirements, something that cannot for the moment be assumed by a third party.

But quite apart from that, there is the political aspect of being seen to reduce the democratization of capitalism – something that is already causing headaches in many jurisdictions. And in the US, policymakers on either side of the political aisle are concerned about the detrimental impact on public markets of a more vibrant private scene.

"I don't think that’s necessarily the right answer for wealth inequality here in the US," notes the practitioner. "The regulators are not going to make it easier for that to happen by propping up more robust private markets."