By Vincent Wess
The shrinkage of public markets is a relatively recent phenomenon and is comprised of two main underlying trends. On the one side, we have seen a deceleration in the IPO market where highly anticipated IPOs, like the one of WeWork, have been cancelled, and new IPOs, such as Uber or Slack, have not lived up to expectations. On the other side, Private Equity firms have further increased their systematic relevance by raising funds on an unprecedented scale and consequently pursuing ever larger buyouts of public targets. These developments have lead to an ongoing shrinkage of the public markets that will be explored and explained throughout this article.
The Process
A take-private involves on the one side a publicly listed company, in a take-private referred to as the target, and a private equity investor, referred to as the acquirer. A take-private, often referred to as buyout or leveraged buyout describes the acquisition of all the publicly outstanding shares of the target by a private equity investor, usually a consortium of several private equity firms or a single private equity firm. The description of such a transaction as a leveraged buyout stems from the commonly used financing structure in these types of transactions. Due to the significant value of the public target and the return expectations of private equity investors, the financing structure tends to show leverage factors between 4-7x times EBITDA, historically, to reduce the equity commitment necessary to close the transaction. The debt burden is reduced over the following years via the target ́s cash flows and the equity portion of the financing mix increases over the time horizon.
On the other side we have the Initial Public Offering (IPO), that describes a complex process in which a previously private company offers its shares to the public market for the first time. Although the process specificities often vary by IPO, the IPO candidate always selects a lead underwriter for the process, often in combination with other banks serving as additional underwriters. Depending on the agreement between the underwriting Investment Bank and the IPO candidate, the underwriter acts as an intermediary or broker between the company that wants to sell its shares to the public and the investors, institutional and private, that want to buy shares in the company. In most cases, the lead underwriter or consortium of underwriters acquires the issued shares in the primary market directly from the issuing company and resells them to the public investors in the secondary market. Given the risks for the parties involved and the legal complexity, an IPO involves several steps and contractual agreements between the IPO candidate and the underwriters. The pricing of an IPO is considered to be one of the crucial parts in an IPO process and is based on both, the fundamentally driven valuation of the target by the underwriters and the willingness to pay of the most important public, often institutional, investors. While there are many advantages associated with an IPO, there are generally two central reasons underlying a firm's decision to offer its equity to the public. Firstly, the issuing company has reached its growth limits given its current financing structure and, therefore wants to raise additional equity in the public markets as an additional source of financing for projects or acquisitions. Secondly, a company is in a better position to retain top management and talent and align company and employee interests more effectively, as it can offer direct participation in the financial success of the company via liquid equity participation, such as Employee Stock Options. Conversely, following the IPO, the public company is subjected to increased regulatory scrutiny and has to follow strict financial reporting and disclosure rules. Additionally, an IPO can create agency problems and lead to a partial loss of control following the attraction of additional external investors with different objectives and opinions in terms of financial and strategic decisions.
Key Drivers of Take privates
Expansionary monetary policies with extensive quantitative easing programs and zero- to below zero interest rates in industrialized countries globally have become a new reality. Macroeconomic developments and dovish monetary policies by the most influential central banks worldwide have strongly contributed to the recent increases in inflows into private equity funds as investors have to move further out on the risk spectrum to realize targeted returns. As of June, 2019, data provider Preqin estimated the dry powder of private equity firms to be a record size of $2.44tn. On the other side of the equation increases in leverage ratios of leveraged buyouts have contributed to a number of buyouts with a leverage factor of 6x or higher that has exceeded the levels prior to the financial crisis. As a report by Bain & Company outlines, the number of “take-privates” is expected to hit an all-time high this year with a number of 212 transactions closed compared to 192 in 2007. This trend is expected to continue at larger scale as the multiples that are being paid for private companies continue to increase and debt markets remain supportive. A growing pool of publicly listed companies are become possible buyout targets for private equity funds.
Graph: Global Public-to-Private Deal Value (Bain Global Public-to-Private Deal Database)
Key Drivers of Declining new listings
The stagnating success of IPOs can partly be attributed to ambitious valuations ahead of going public. Many of these companies are described as industry disruptors and have an element of technology or software integrated in their product. The associated tendency that these companies should produce similar gross margins to software companies, which lie usually around 75% and above, is commonly false. Whilst tech-infused, the product is not of the same nature and thus has to be valued differently for more representative valuations, in accordance with product, market, margins and business model. Moreover, large payouts are affiliated with initial growth phases, when firms still find themselves in private hands, raising the question whether public markets will soon largely retain mature businesses.
Additionally, since the boom of tech-companies 20 years ago, investors are more mindful to analyze business models behind the company and the assurance of sustained profitability.
Investors are simply reacting to the realities regarding new listings, with only 14% of tech companies being profitable this year and no obvious path for future profitability existing. This becomes of particular importance now as the response to disappointing IPO’s such as Uber and WeWork, as well as the macroeconomic landscape around public markets becomes more drastic. In 2019, 38 IPOs were pulled this year compared to just 8 in 2017 with the most notable example being the much anticipated IPO of WeWork.
Another dominant factor is the macroeconomic landscape, which has driven market volatility. Listings across Europe, the Middle East and Africa suffered the sharpest fall this year. The 179 IPOs marked a 40 per cent drop from 2018, linked to the political phenomenons facing these regions. With the added pressure on the EU surrounding Brexit, the listings on the London Stock Exchange dropped 62%. Ernst and Young expects the outlook for global listings to increase in the last quarter of 2019 and into 2020 when more certainty exists surrounding Brexit and the US-China trade tensions.
Although the suspicions about an incoming recession have alleviated, a recent Preqin survey uncovered that around 74% of investors assumed that the market is at peak in the second-half of 2019, meaning that a downtrend is close and the fear of an upcoming economic slowdown keeps investors alert and away from possibly volatile investments.
Graph: Global IPO Volumes By Region (Financial Times)
Further Trend Analysis
The decline in IPOs and shrinkage of public markets has been visible over the past two decades. However, a sharp drop in IPO’s in 2019 has emphasized the concerns and increased the severity of the trend. In the third quarter of 2019, 256 IPOs came to the market, a 24% decrease by volume and 22% by proceeds compared to the third quarter of 2018. The decline becomes even more noticeable when comparing the global number of IPOs in 2017 at 1,624 with 1,359 IPOs in 2018. What is particularly interesting to observe is that the decline in IPOs and thus the shrinkage of the public markets comes at a time where the majority of external factors are largely supportive. A low interest environment, high amounts of deployable capital as well as high stock valuations usually tend to be associated with strong IPO activity as firms try to benefit from high equity valuations to raise sufficient cash. However, many firms realize the substantial cost and strategic burden of regulatory transparency rules and investors have started to question valuations, especially of tech IPOs, more intensively, given the already high valuations and geopolitical uncertainty in the global markets.