Private Stock Exchanges for Start-up Companies

SecondMarket and Shares Post are private exchanges where start-up companies' stocks can be traded by investors and employees without having to go through the rigorous IPO process.  Unlike the public exchanges, companies selling shares on the private exchanges can choose which investors are allowed to buy their stock and limit the frequency of transactions.  For example, they may restrict the investor to trade their shares four times in a year.  Companies are able to retain their employees until they are ready for an IPO.  For these emerging companies, there is a market value.  In the traditional process, the investors are reliant on valuations from the venture capital and private equity firms that own them.

Barry Silbert, CEO of SecondMarket, believes the IPO market is dying.  In the last ten years, there have been between 100 to 150 IPOs per year.  There were 400 to 500 per year in the 1980s and 1990s.  It takes ten years for a company to go public since its founding.  It was five years in the 1980s and 1990s.  The growth of online brokers and the end of research from the banks are also factors in this trend.

The source for this article can be accessed here.

Another Private Equity Shop Wants an IPO: Carlyle Group

Following in the footsteps of Blackstone and Apollo Management, the private equity company Carlyle Group has filed an IPO with the SEC.  It should be closed in the first half of 2012 and raise $100 million.  Carlyle had first attempted to go public before the credit crisis of 2008.  The other private equity firms' stock prices have been failures, to say the least.  Blackstone went from $31 to $12.50 and Apollo's stock is down 33% since the IPO.  John Duffy of Keefe Bruyette & Woods had predicted this outcome.  He said, "If guy like Schwarzman are selling, I don't know if you want to be on the other end of the trade."

Sources for this article can be accessed at Crains and Finalternatives.com.

Internet IPOs 2.0

Morgan Stanley has been an underwriter of many large technology IPOs this year.  The companies include LinkedIn, Yandex - a Russian search engine and Renren - a Chinese Facebook.  They popped over 100%, 55% and 30% on the first day of trading respectively.  The target percentage gain is usually 15%.  The high returns are reminiscent of the internet bubble of the late 1990s.  Internet companies are hard to value.  There are almost no peer companies to use for comparison purposes.  The private markets, where Facebook is traded, does not serve as a useful benchmark for the public markets.  Transactions are infrequent and for the privileged few.

For more information, the source for this post is here.

Reflection from the Technology Bubble

During the technology bubble in the late 90's, some investments banks created a theoretical profit and loss statement based on the performance of their IPOs. Because many deals doubled or tripled during the craze, some of the profits were astronomical.  The sales force was encouraged to "request" that buyside clients' trading commissions be two to three times the theoretical profit.  Following that metric produced projected annual sales credits that were above what the firms normally paid.  So, sales management and the investors worked out a deal.  To generate the desired ratio, institutional clients would pay trading commissions about the standard rate i.e. instead of a normal $0.05 per share, the commission would be $0.10 per share.  The bank's sales management cleared this with the legal and compliance department.  After the investigation, legal and compliance admitted to signing-off on this arrangement but thought it was only for a few firms.  It did not know that it would apply to many firms.  In the end, sales management was fined and suspended for a few months.  I do not know if anything happened to legal and compliance.

Using a Hypothetical IPO Performance Report to Gain Market Share

One of the pieces of information used by institutional salestrading and research sales to leverage more trading commissions from the buy-side was the profit and loss statement based on the performance of the bank's IPO's.  This was done by, at least, two banks and, probably, all of them.  The report was a scorecard of how much money the fund managers would have made (the hypothetical part of the exercise) if they would have held the IPO for 1 day, 30 days, 60 days, 90 days, 6 months and 1 year.  It was a relatively simple calculation.  For each of the intervals, the difference in that day's and the offering price was multiplied by the allocation received by the manager.  For example, a fund was given 1,000 shares, the offering price was $15 and the first day's closing price was $20.  The profit would be ($20 - 15) x 1,000 = $5,000.  The idea was to receive commissions equal to twice the hypothetical profit.  For a large investor involved in many deals, the report could become quite large.  During the technology bubble, some of the profit numbers were astronomical.  Of course, these numbers were quite theoretical as many funds sold parts of or the entire position before the timeframes used on the report.  It was the pursuit of the profit numbers that led to Credit Suisse $100 million settlement with the SEC in 2002.

Dutch Auction Initial Public Offering

In an earlier post, the traditional method of an initial public offering was summarized.  The price of the new stock is determined by the lead investment bank and the company.  Another method to set the offering price is to hold what is called a Dutch Auction.  This was pioneered by the boutique technology investment bank W.R. Hambrecht.  The bank sets the number of shares and share price for the IPO.  When the sales force engages their buy-side clients, they are given the number of shares wanted (indication of interest) and the price at which the client will buy the deal.  Once the minimum price is established, shares are issued to the clients that bid the minimum and greater.  The shares are at that price.

For example, the IPO may be set for 1,000 shares and $100 initially.  The aggregated bids from all investors may be:

• 200 shares at $100
• 400 shares at $95
• 300 shares at $90
• 400 shares at $85
• 500 shares at $80
• 500 shares at $75

The bids reach the 1,000 share level at $85.  The investors that bid $90 - $100 will receive 900 shares at $85.  The remaining 100 shares at $85 will be distributed to those investors proportionally.  If an investor asked for 100 shares, 100 x 0.25 = 25 shares would be allocated.  Any order under $85 would not be fulfilled.

This method is not popular with the banks because they receive a lower fee - about 2% of capital raised versus 7% - for the deal.  It is not popular with the buyside because it will usually not jump in price and pave the way for quick profit taking on the first day of trading.  On the other hand, the issuing company can get more capital from the IPO.

Growth in China Deals

An article in the March 2011 issue of Global Finance magazine (http://www.gfmag.com) said that Chinese companies had raised $4 billion in 31 new depository receipt programs in 2010.  This represents 80% market share of Asian receipts.  In terms of global IPOs (including common stock and depository receipts), China had 18 of the largest 25 deals and raised 26% of the world's capital.  The activity was caused by improving equity markets and by many companies deciding to expand after the economic crisis.  The threat of inflation is the only overhang in the present.

The article references a table from Citi Depository Receipts year-end 2010 report.  The top 10 Asian companies, in terms of volume, include Baidu, Taiwan Semiconductor, JA Solar Holdings, Suntech Power Holdings and United Microelectronics.

Introduction to Leveraged Buyouts

As venture capital invests in emerging companies, leveraged buyouts invest in established, underperforming companies.  The most common scenario is a private equity fund, the merchant bank division of an investment bank or the target company's management buying a publicly traded company.  The company is taken off the markets and becomes private.  Since the initial investment (cash or equity) is usually low, its assets and cash flow are used to finance the transaction.  Financing is a combination of equity and debt with 40% to 60% being senior debt, 20% - 30% being mezzanine debt and 20% - 40% being equity.

The private equity fund has a general partner that makes the investments and several limited partners that are the investors.  The investments are usually reviewed in the first five years of the partnership.  The partnership normally lasts ten years.  As the fund exits its investment companies, the investors receive their profits.

So, how does a private equity firm turn a company that is an unattractive investment to one that everyone wants to buy?  They can improve operating efficiency, create an entrepreneurial mindset, streamline companies, build up companies and turnaround companies.  Improving operations means that there is closer oversight of the company and improved management.  The approach for creating an entrepreneurial mindset is to allow management to improve the company or carve out a subsidiary to follow its own agenda.  Streamlining and building up companies are strategies that are the opposite of each other.  The streamlining strategy means to concentrate on a firm's core businesses while the building up involves combining several companies.  The hope is that the whole is greater than the sum of the parts.  Turnarounds take underperforming companies into outperforming companies.  In each of the strategies, the private equity fund will have members on the board of directors of the target company.  They will help the board in running the company more efficiently.  Taking the firm private allows the company to concentrate on its business rather than focusing on making quarterly projected earnings per share demanded of a public company.

In venture capital, the investor cashes in on the company through an initial public offering or a sale to another company.  For leveraged buyouts, the same exit strategies are used.  Additionally, the company can have another leverage buyout, a straight refinancing or sell it to another private equity firm.  In both the second buyout and straight refinancing, the company adds more debt in order to reward company management or the equity holders a dividend.

Greenshoe or Over Allotment Option

In the prospectus for an IPO, the investment bank is sometimes given an over allotment option, also called a greenshoe.  It gives the bank the right to sell 15% more shares beyond the original deal.  The strike price of the right is the offering price.  It's the only legal way to stabilize the aftermarket for an IPO.

Scenario 1:  The deal drops below the offering price.  The bank over allocates the number of shares by 15%.  In essence, it has a short position where the shares are sold at the offering price.  When the share price goes down, the bank buys it back at or below the offering price until its short position has been closed.

Scenario 2:  If the IPO trades higher than the offering price, the bank still over allocates the shares by 15%.  If it is unable to buy back any shares at the offering price, it avoids a loss by exercising the full greenshoe.  In the case where it is able to buy some shares, it will exercise a partial greenshoe.

Allocating Shares for an Initial Public Offering

In the last article, we went through the IPO process.  There are two major parties on the sellside that handle the deal:  equity sales and capital markets.  In the days leading up to the IPO effective date, salestraders are entering their indications of interest;  that is, the number of shares that their buyside clients want and any additional color that may help their clients get a larger allocation.  For a hot deal, buyside firms know that they will not get their number so they overbid i.e. I really want 100,000 shares but I'll order 200,000 to get it.  After the orders are placed, sales and capital markets management start allocating the IPO shares.  They will initially speak with the issuer company on some broad outlines.  The CEO may instruct the bankers to give minimal amounts of shares to hedge funds.  He may be afraid that they will "flip" the shares on the first day.  By "flipping", the fund makes a quick profit by selling the shares - providing that the IPO appreciates.  Or make sure that this fund gets a good allocation as they are a "friend of the firm".

Management will look at the following criteria (in no particular order) for the allocations:

• Amount of secondary commissions done with the bank
• For the last 3 months in the IPO's market (for example, for Netscape's IPO, management would look at US commissions)
• For the last 6 months in the IPO's market
• For the last year compared to the prior year in the IPO's market
• For the last year compared to the prior year global equity markets
• For the last year for derivative and convertible securities
• Amount of primary commissions done with the bank for the year compared to the prior year
• Amount of total commissions done with the bank (secondary and primary) for the year compared to the prior year
• Ranks for each of the commission categories above
• The fund promises to buy aftermarket shares
• The fund is a notorious flipper
• The fund's strategy is buy and hold

Primary commissions are equivalent to the selling concession from a deal.  Secondary commissions are from everyday trading of previously issued securities.  Note that the broker vote does not seem to hold much weight.

Institutional Sales and the Initial Public Offering

Equity sales and capital markets cooperate to sell and distribute an initial public offering to the buyside.  Institutional sales gets involved after the preliminary prospectus has been filed and approved by the SEC.  As part of the daily morning call, capital markets will hold a kick-off meeting between the issuer company's management, the covering research analyst, the sales force and traders.  From that call, research salespeople and salestraders will notify their clients of the deal and gauge possible interest in the IPO.

The IPO is marketed to interested clients through a roadshow run by capital markets.  Here, the issuer company's senior management will present their business plan, future prospects, market position, etc. to the buyside.  This will be a grueling death march for 3-4 weeks where they will travel all over the place to meet with portfolio managers, research analysts and traders.  At a minimum, they would go to New York, Greenwich, Boston, Philadelphia, Chicago, Houston, Los Angeles and San Francisco.  If they wanted to sell shares to European firms, then London, Paris, Frankfurt, Amsterdam, Madrid, Milan, Geneva and Zurich would be added to the itinerary.  While the roadshow is progressing, the sales force is gathering the buyside's indications of interest, their pricing expectations and the number of shares desired.  Sometimes, the buyside firms commit to buy additional shares in the aftermarket if their order is filled.

The terms of the deal will influence how aggressively a deal is marketed by the sales force.  A deal with a fixed allocation of shares will not be promoted heavily.  For example, the distribution of shares for a deal may be 60%/40% between Credit Suisse and Morgan Stanley.  Since this is guaranteed for both firms, the sales force will not be as excited as for a deal with a flexible allocation.  For example, a deal may be allocated 50%/40% with a 10% jump ball.  In this case, the first firm may get as much as 60% of the sales concession if they sell it aggressively enough to their clients.  When the IPO's orders are being filled out, the buyside firm will tell the managing underwriter the number of shares to credit each bank.  In all cases, the sales force will be more excited when their bank is the bookrunner as a majority of the selling concession is headed their way.

The night before the offering date, the issuer company, sales management and capital markets meet to set the price and number of shares in the deal.  Sales management and capital markets also set the final allocations to the buyside.  The capital markets trading team stays in the office very late to process them.  Then the stock is distributed to the investors and begins trading the next day.  If there are any selling order imbalances, the position traders assigned to the IPO must step in and stabilize the price.  In the months following the offering, the lead underwriter's traders provide liquidity by making a market on the stock.

Initial Public Offering: A High Level Summary

One of the exit strategies for a private equity investment is the initial public offering (IPO).  The company hires a group of investment banks (the syndicate group) to issue equity shares that will be publicly traded on an exchange.  The cash generated in the offering goes to the company with a fee going to the banks.

The fee is usually 6%-7% of the size of the offering.  One of the banks will be the lead underwriter or bookrunner of the IPO.  Other members of the syndicate will take lesser roles.  For a large deal, there may be co-bookrunners but, honestly, only one firm can be the lead.  This can be determined by looking at the offering documents and seeing which bank is on the top left.  Besides the lead managers, there are also underwriting and selling groups that have lesser levels of responsibilities during the IPO process.  The managers and the issuer company choose which firms will participate in the deal and at what level.  At times, issuers have thrown out banks that have displeased them.

The fee is distributed among the three levels in the syndicate group.  There is a 20% management fee for the managing underwriter for determining the structure of the IPO, running the marketing program, doing due diligence on the prospectuses and creating the syndicate.  An underwriting fee of 20% is for the managing underwriter and banks in the underwriting group for assuming transaction risk.  They are buying shares from the issuer company and selling them to their investors.  If any shares remain on their books, the banks have to keep them.  The selling concession is 60% of the fee and goes to all three groups.  It's a finder's fee for getting investors to buy the IPO.  The terms of the deal may have a strict or flexible allocation.  In the latter case, the buyside investors allocate the fees among the different members of the syndicate.

To start the process, the issuer company must register with the SEC and file a preliminary prospectus commonly know as the red herring.    The registration statement contains a description of the issuer's business, information on company officers (names, addresses, salary and five year biographies) and their ownership levels, market capitalization of the firm, description of how the proceeds will be used (i.e. to pay down debt or expand the business) and any legal proceedings.  The preliminary prospectus has the information in the registration statement plus:

• Offering price range
• Option agreements
• Underwriting commissions and discounts
• Balance sheet
• Last three years of earnings

After the documentation is filed, there is a 20 day cooling-off period between filing and approval dates.  Here the issuer and syndicate group cannot discuss the IPO outside of the information in the preliminary prospectus.  The final prospectus is created when the SEC confirms that all the information needed is in the document.   This includes everything in the preliminary prospectus plus the final offering price.  While waiting for approval, the banks are asking buyside investors for their indications of interest to get an estimate of demand and the best price for the deal.

Leading up to the first day of the IPO, sales management and the capital markets desk allocate shares to the institutional investors.  For an oversubscribed or hot deal, not everyone will be getting their entire indication.  Actually, that can be said of any deal.  To ameliorate some of the demand, a greenshoe or over allotment option that gives the banks the right to sell an additional 15% of the shares is exercised.

The day before the IPO's effective date, the issuer company and lead underwriter determine the offer price and number of shares distributed.  After these terms are finalized, the final prospectus is published and sent to the investors.  The deal is closed three days later when the issuer receives the proceeds and delivers the stock to the bank.  The bank then sends it on to the investors.

On the first thirty days of trading, the banks are on the hook for stabilizing the market for the IPO.  In the case that the shares go down in price, they are repurchased.  The banks use the over allotment option to hedge for this event.  The bookrunner has the largest market share for any secondary trading of the IPO.  

After the offering is completed, the banks in the syndicate cannot initiate any research coverage on the issuer for forty days.  Afterwards, they, especially the lead underwriters, will write a report - usually with a buy rating.

This is a summary of a regular IPO.  The Google deal was a dutch auction IPO and will be dealt with in a later article.

Venture Capital: Growing Start-Ups

Venture capital made its mark during the dot-com era about ten years ago.  There were $100 billion of capital committed for the strategy at its height in 2000.  In the early 1990's, they totaled $5-$7 billion annually.  The strategy invests in young, emerging companies.  Because these companies are small and illiquid, banks and normal investors deem them as too risky for their portfolio..  Venture capital funds target high returns, about 30%, for this risk.  Looking at the three, five, ten and twenty year returns, venture capital investments beat the S&P 500 by a significant amount in all the different stages of funds.  There are three types:

• Seed Capital / Early Stage:  Invest in companies with little or no revenues
• Late Stage / Mezzanine Stage:  Invest in companies with revenues
• Balanced:  Mixture of above two

Investors usually have to keep their money in the fund for at least ten years.  As a result, pension funds, endowments, foundations, high net worth individuals and fund of funds are the sources of capital.  In 2008, pensions invested in 50% of all venture capital funds.  This was down from 70% in 1990.

There are five stages in the life cycle of a fund:

• Fund raising:  Take six months to a year to gather capital commitments
• Finding investments:  Take up to five years to conduct due diligence on start-up companies
• Investment of capital:  Invest in different companies
• Monitoring and managing portfolio companies:  After funds have been invested, the venture capital fund's principals grow the company for an IPO or to be sold to another company
• Windup and liquidation:  IPO or sale is closed or company is liquidated

Investing in venture capital takes a lot of patience.  The payoff is ten years into the future.  The investment has a negative return for the first five years as management fees are collected but no profits are created.  This is called the J-curve.

Effect of the Technology Bubble on the Broker Vote

In the previous article, there was a short summary on the analyst level detail of the broker vote.  During the technology bubble in the late 1990's, there was a distortion in the vote.  At that time, the analysts covering the technology (especially Internet) sector received an increased number of votes at the investment banks.  This was an attempt to curry favor with the analyst in hopes of getting an allocation to a hot/oversubscribed IPO.  As with many situations in investment banking, this was unspoken.  On the whole, an analyst of the lead underwriter of the IPO would have a favorable reputation and the comment would be:  "He/she gives valuable insights."