April 7, 2017    11 minute read

The True Nature of the IPO Market: Capital, and Then Some

The Underlying Incentives    April 7, 2017    11 minute read

The True Nature of the IPO Market: Capital, and Then Some

The last year has been a year of great change, and some of its effects have already managed to penetrate and greatly influence particular industries. This is quite evident in the IPO market, where a backdrop of both political and economic uncertainty has reduced both the capital raised and number of deals in 2016 when compared to the previous year. Yet, to truly understand the forces at play within this market, one ought to dig much deeper into the historical trends and intricacies which have resulted in the industry with which we are faced at the now and which will continue to shape its future.

The IPO Market: Perverse Incentives?

A new malaise has gripped the world, clasping public sentiment and bringing to the forefront the numerous issues and problems which previous governments failed to address. Whether this is a blessing in disguise sent forth to spur those who wish to promote a more liberal and open worldview into more decisive action and less ideological debate is yet to be seen. Either way, it is taking its toll on today’s capital markets in interesting ways.

The entire process of completing an IPO is a complex one, determined by an increasingly large number of factors which need not be limited to those political ones. An obvious example would be the availability of alternative sources of capital, which in turn depends not only on other markets and their functioning, but also on numerous legal and political debates which vary from nation to nation.

Any legislature which affects, for example, the US dollar treasury market has the potential to (albeit often minutely) affect how a large European tech company structures its IPO. To complicate things further, the large impact that investor expectations play on stock market prices also morphs the incentives behind how and when IPOs are structured. It becomes obvious that firms do not go public solely when they need to raise equity capital, even if this remains the ultimate goal. They must time the issuance of these securities such that they occur when market conditions are more conducive.

All of this is only the tip of the iceberg. With such an intricate web of factors, incentives and players, the question remains as to whether the textbook notion of equity markets serving only as a way for ‘Main Street’ businesses to raise capital has somehow changed to something more elusive, complicated and ultimately unnecessary.

A Once-in-a-Lifetime Opportunity

EY’s Global IPO Trends Report for the fourth quarter of 2016 notes that we are living in an era of a “new kind of IPO” in which we see companies choosing to go public later in their life cycles. They are thus often of a large enough size that they possess a certain degree of stability in their business operations.

For such companies, an IPO becomes much more than a once-in-a-lifetime opportunity to raise equity finance. Indeed, the report notes that two of the main drivers which push modern day businesses towards public markets are the “need to secure a higher brand profile and the opportunity to access new markets via cross-border listing opportunities”. Yet, it must be mentioned that in the fourth quarter of 2016, cross-border listings represented 6% of global IPOs as compared to 8% during the same period of the previous year.

Japanese Ambition

Japan’s Line Corp, which opted for a New York-Tokyo dual-listing, is perhaps one of the most prominent examples of a recent IPO that had initially been interpreted as a move to expand operations and challenge global rivals. As a messaging app service provider, LINE has had a strong foothold in Japan and Southeast Asia with around 218mn active monthly users at the time of its IPO. Roughly 77% of these users are from either Japan, Thailand, Taiwan or Indonesia. These figures pale in comparison to those of the global market leaders of the industry WhatsApp and Messenger, both of which are owned by Facebook. Their current monthly active user bases are 1.2bn and 1bn, respectively.

Line Corp’s IPO came at a time when various groups of investors questioned the viability of the company’s advertising revenue strategy as well as its ‘prospects for regional expansion’. Nonetheless, Line managed to raise $1.3bn, making it the second largest IPO by proceeds within the global tech sector in 2016. In this regard, it had been a total success.

Whether or not it has managed to have a positive, long-term contribution towards raising brand recognition of the world’s 7th most-used messaging application remains questionable. If they choose to focus more on ‘domestic growth’ as opposed to ‘global expansion’, as Jung-ho Shin, co-founder and chief global officer of Line, had told CNBC in an interview, it becomes difficult to see how this could ever be the case.

Knowing all of the aforementioned, can it then be claimed that the IPO of Line Corp falls into the category of one of those ‘new kinds of IPOs?’ After all, the company had launched its app in 2011, making it only 5 years old at the time. When this is considered, along with the fact that their main revenue drivers, advertising and sticker sales, are part of a more general trend of online messaging which had only begun to truly boom in the past half a decade or so, it seems absurd to do so. It would therefore be more appropriate to turn towards an IPO of a business which operates within an inherently more stable industry, such as that of Innogy SE in Germany or of JR Kyushu Railway Company in Japan.

Every Business Has A Story of Its Own

The $4bn IPO on the Tokyo Stock Exchange of JR Kyushu Railway Company, the state-run bullet train, property and railway operator, and the $5.2bn IPO on the Frankfurt Stock Exchange of Innogy SE, the renewables, grid and retail arms of its parent, RWE AG (Germany’s largest power producer), stand as the third and second largest deals of 2016, respectively. Yet, if one were to analyse each issuance and the motives behind them separately, two very different pictures would appear.

Globally, when JR Kyushu Railway Company went public, it was the third largest deal in 2016. What is unique about this case is that it was a privatisation of a previously state-owned company. The government had decided to sell the entirety of its 100% stake in the company: 160 million shares held by the state-controlled Japan Railway Construction, Transport and Technology Agency. Roughly three-quarters of these were offered to domestic whilst the rest were sold to overseas investors. Ultimately, the IPO served as a way for the government to boost retail investment within the country, as Prime Minister Shinzo Abe tried to persuade citizens to invest some of their roughly 1700tn-yen household savings into the stock markets.

Ultimately, the IPO served as a way for the government to boost retail investment within the country, as Prime Minister Shinzo Abe tried to persuade citizens to invest some of their roughly 1700 trillion yen of household savings into the stock markets. JR Kyushu did not gain any money from the offering.

Despite the IPO serving as a political tool for Japan’s prime minister, JR Kyushu is first and foremost a company which exists to provide particular goods and services. Its stock will continue to trade above its offer price only if the company can continue to create value for its shareholders. In this regard, the effects that the IPO will have on it remain inconspicuous, if not nonexistent. The focus remains on seeing how well JR Kyushu can grow its station and real-estate businesses that include hotels and shopping centers on Japan’s third biggest island.

A Different Tale

The story of Innogy SE is a completely different one. This particular IPO was the result of a long period of falling profits at RWE’s core business of conventional power generation. For those who have followed recent developments in the utilities’ markets across Europe, this will come as no surprise. Intense pressure from renewables has depressed prices across the entire industry and investors have responded accordingly by discounting and even dumping certain utility stocks.

The problem plaguing the industry can be traced back to a number of differing factors. In general, it can be argued that the enormous subsidies of roughly $800bn since 2008 – which governments have introduced across the developed world as a way to force the decarbonisation of global energy supplies – have simply distorted the market.

They have been imposed on a market which was designed in a period characterised by large, vertically-integrated state monopolies. The negative effects and price depreciations caused by the subsidy system are only compounded by the intermittency and low running costs of alternative energy sources such as wind and solar. Thus we are left with an industry characterised by constantly decreasing profit margins.

The IPO of Innogy is therefore seen as a relief by many. The fact that Innogy’s CEO, Peter Terium, insisted that the company seek a separate, standalone credit rating for what he calls “a very stable, investment-grade company” – suggesting that the main goal was the creation of a separate entity to attract investors who wish to have direct exposure to regulated assets with steady returns. S&P has given Innogy a credit rating of BBB-, which is the minimum rating a security can receive to be classified as ‘investment grade’. After the IPO, RWE remains the major shareholder of Innogy, with roughly 75% of the company’s stocks in its possession and the two maintain separate businesses.

More Than Meets the Eye?

After careful consideration of the motives behind each company’s individual reasoning for turning towards public equity markets to seek funds, it becomes apparent that they choose this route due to often widely diverging reasons.

This is, of course, nothing out of the ordinary. Yet, it does imply that the process of issuing stock is always something more than simply raising capital. The existence of complex, finely tuned equity markets create opportunities for firms to improve overall efficiency via artificial, financial creations, as opposed to altering aspects their real business.

Will the fact that Innogy has separated from AWG directly translate to better performance for its shareholders and better products and services for its customers? Without effective management, going public can prove completely ineffective. Yet, it has created more room for them to breathe, removing the burden of the far-reaching parent. The same holds true for Line Corp: the fact that it is now listed on the New York Stock Exchange does not guarantee successful penetration of the US market. It does, however, improve the company’s financial position and puts it at the centre of world finance.

As these markets become more developed and the products and services of investment bankers and other experts improve over the years, firms will only be able to accomplish more and more by going public, changing the inherent nature of the IPO market itself.

Cash and Control

That the IPO market is first and foremost a business, where clients (firms) approach a service provider (investment bankers), is perhaps nowhere more evident than in the US tech sector. Such companies often come seeking two things: to raise funds and stay in control. This is accomplished by structuring their IPOs in such a way that they end up issuing multiple classes of stock.

As data published in the Wall Street Journal shows, 15% of the tech companies that went public in the US between 2012 and 2016 did so with at least two classes of stock. Having multiple classes allows the companies to assign differing voter rights to each class individually. As the aforementioned article reports, Facebook has two different classes: A and B. The former allows one vote per share, whilst the latter, held by CEO Mark Zuckerberg and other early investors, allows ten votes per share. Snap’s recent IPO was the first in the US since 2000 in which no voting rights whatsoever were given to new shareholders. The company has three classes of shares.

As global economic growth trudges onwards on its upward trend, so will the growth of the overall global IPO market. Sponsor-backed IPOs, which represented roughly 64% of IPO proceeds in 2016, will remain a key driver of activity, as they have historically been. Estimates provided by Preqin show that there is roughly $820bn being held as ‘dry powder’ by private equity funds (as of December 2016 figures).

As long as equity markets provide the liquidity needed to ease exit strategies, companies held within these funds’ portfolios will continue to be a key source of IPO candidates. Thus, investors are poised to see an ever-evolving landscape in the IPO market, where each individual company wishes to not only raise capital, but also accomplish something different than the next.

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