Letter number 138 of July 2021
- QUESTIONS & COMMENTS
An IPO is a complex operation requiring a lot of preparation and which, in the end, is quite expensive. To the significant direct costs (legal fees, bank fees which amount to a few percent in Europe and which climb to 7% in the United States), we need add the dilution and/or reduced proceeds linked to the IPO discount. While several theories seek to explain the existence of such a discount, it is not only theoretical and takes on concrete form in the difference between the IPO price and the first listed price. Even if it changes over time, depending on the sectors and listing places, it is often greater than 10%. But these days, in a rather particular stock market context for a certain number of stocks, it can be much higher: 4 days after its IPO, HRS was trading at 72% above the IPO price, after a + 30% on the first day, it is true that the H in its name stands for hydrogen… As for Medesis Pharma, it saw a 59% increase on the first day. So, between the fees and the IPO discount, the real cost is between 15 and 20% of the amount raised, whether this is paid by the company, borne by the selling shareholders as a discount on the real price of their shares or by all shareholders through excessive dilution.
In addition, traditional IPO methods suffer from another major drawback: the success of the operation is largely linked to the health of the financial markets at the time of the actual execution of the transaction. Thus, an IPO prepared over 6 to 9 months will sometimes have to be postponed by several weeks (or even more) before it sees the light of day, if it ever does see it, and may sometimes even be postponed the day before the D day.
Two new types of operations have developed in recent years to overcome the two pitfalls mentioned above: direct listing and SPACs. It should be noted right away that these methods are certainly not intended to replace all traditional IPOs, but probably only a some of them.
Direct listing is an extremely simple listing method: a company wishing to list its shares simply registers them on a regulated market and leaves supply (of shareholders wishing to monetize their investment) and demand (of investors wishing to buy shares) to set the equilibrium price. In France, a minimum price is set to ensure that investors are not robbed; in the United States, a reference price is indicated but has no binding value. This technique therefore does not require the involvement of a bank, as is the case with an IPO through the construction of an order book.
This technique is normally less expensive than an IPO through construction of an order book, because the company saves bank fees and above all the operation is theoretically done without a discount for the selling shareholders.
But direct listing does not only have advantages. First, the company cannot raise funds through this method, only existing shares are traded. Furthermore, the sale of large blocks of securities is not possible or not optimal. In fact, investor demand can be relatively limited in the absence of a major marketing exercise carried out by banks when building the order book (book building with meetings with investors, dissemination of analysts' notes, etc.). Finally, in the absence of a method for price discovery before listing (which is in reality book building), and of mechanisms to limit price variations (greenshoe, lock up), the share price volatility during the first weeks of listing is likely to be significantly higher in the case of a direct listing than in the case of a traditional IPO.
Direct listing is therefore reserved for a certain type of company: already well known to investors (and therefore generally of large size), with an already large shareholder base (often made up in part of the company's employees), wishing to give a liquidity to the latter, but not needing to raise funds.
Spotify chose this IPO method in 2018, followed by Slack in 2019 and Asana and Palentir in 2020.
In Europe, this technique has been used mainly in the case of spin-offs (ArcelorMittal / Aperam, HiPay / HiMedia for example).
SPACs (Special Purpose Acquisition Company)
SPACs are often presented as “blank cheque” companies where investors have so much confidence in an investment team (and have so much cash to put in) that they agree to invest in a company without knowing what its activity going to be . This is a rather simplified view of the situation.
There are in fact mechanisms that actually allow SPAC investors to exit if the acquisition is not to their liking. Unlike a typical business where shareholders very rarely have a say in acquisition transactions, SPACs shareholders have the right to vote for or against the first acquisition transaction (known as despacking). This operation is obviously capital because it allows the SPAC to fulfil its mission. It's important to remember that if the managers of a SPAC do not succeed in finding an adequate target within 18-24 months, in general, the vehicle is dissolved and the funds returned to the shareholders. It is quite natural for investors to be able to vote on this operation because, with the lead time to complete the operation, the management of the SPAC is under increasing pressure to carry out an operation, even one that is mediocre or too expensive. At the time of despacking, shareholders can also choose the reimbursement of their initial investment. Paradoxically, this latter possibility actually prompts them to vote in favour of the operation irrespective of their view of it. If they think the operation is going well, they vote for it and stay; otherwise they vote yes and leave, requesting reimbursement of their shares. But by asking to exit, they can jeopardize the operation because, if the SPAC does not have sufficient funds to complete the acquisition, it will be cancelled ...
In addition, it is quite rare for the operation to be carried out for an amount less than or equal to the amount raised by the SPAC initially. In reality, most SPACs raise a few hundred million euros, but aim to carry out much larger operations (in the United States at least). Thus, it is not uncommon for a SPAC that has raised $ 200 million to carry out an operation of more than $ 1 billion. In this type of situation, management does a mini roadshow when it has secured the acquisition with institutional investors shareholders, but also potentially with new investors to highlight the merits of the acquisition and seek new investments. This is a second validation by the market of the rationale and the price of the acquisition.
A second criticism that is sometimes levelled against SPACs is that the management of the SPAC receives 20% of the shares when the SPAC goes public (i.e. when it is created) almost for "free". There are those who find this shocking. A few comments on this point. First, management invests funds that are admittedly limited (a few million dollars or euros) but at a real risk, because if the SPAC does not “despack”, the funds are lost (these funds are used to pay the operating expenses of the SPAC and the costs of its initial public offering). In addition, this goodwill rewards the real know-how of the small management team, a network, an ability to detect an operation that creates value. This is similar to what we see at start-ups, where founders value their work and their ideas through a greater share in the capital than their share in the financing, even after all the fundraising. In addition, these free shares represent 20% of the initial capital, and not the final size of the transaction (i.e. $ 200 million, in our example, and not billion(s)). Finally, the 20% is sometimes revised downwards by management itself when it seeks to convince investors to despack. Our sharpest readers will notice that this provision of SPACs is an option held by management on a future deal.
Is it better to be listed on the stock market traditionally or to be acquired by a SPAC?
It should be noted first of all that the initial shareholders of the target of a SPAC can negotiate to be paid in shares of the SPAC and thus not cash in the whole of their investment. The results of the two operations can therefore be quite similar (a SPAC is not necessarily synonymous with a complete acquisition and a change of control).
Exiting shareholders transferring to a SPAC save on the IPO discount, since the company is sold by mutual agreement.
For the remaining shareholders, if the company has to raise funds during the operation, the IPO discount must be weighed against the dilution linked to the free shares granted to management of the SPAC and the warrants.
Institutional investors do not benefit from the IPO discount but they guarantee themselves a place of choice in the operation, which an allocation in a traditional IPO would not have allowed.
The real losers are the investment banks who receive a much lower fee than for a traditional IPO. But after all, this is just the smart response of investors to a very concentrated market, the investment banking market in the United States, that perpetuates undeserved income streams.
These new IPO methods are therefore certainly intended to co-exist alongside the traditional method. It is likely that these two methods will develop in Europe, even if the appreciably more reasonableness of banks' fees will certainly curb this development.
These new methods still suffer from an image problem: direct listing exists in Europe, but mainly for small companies; SPACs are often viewed as financial rogue operations. But their institutionalisation across the Atlantic, 219 SPACs raising $ 79 billion (against $ 67 billion for traditional IPOs in 2020), will change this image, and we believe that they will survive the current stock market context (+462 % compared to 2019) which is carrying them at the moment, given that investors are eager to dream.
 As the US market is significantly less competitive and dominated by a few large banks, fees for accessing capital markets, but also for M&A advice, are higher than in Europe and fairly widely standardized. No bank dares to break these standards ...
 All the more so if the despacking is proposed near the fateful end of life of the SPAC ...
The research teams at Société Générale have published two interesting graphs that illustrate the different treatment of these subjects on the two sides of the ocean that separate us.
The first one highlights the lasting impacts of the 2011-2012 euro crisis on the ability of European companies to return to their shareholders the excess equity they generated from their operations. Whereas before 2010, American companies returned about twice as much, after 2012, the order of magnitude is 4 to 5 times more!
This is the mark of the extraordinary rents built by the GAFAMs (the operating margin of the App Store is said to be 78%, even Hermes can't do that), and other companies that are less publicized without being less profitable (Oracle has an operating margin of 36%, compared to 24% for SAP); a culture that favors, more than on the Europe, the circulation of money via dividends and share buybacks that finance pensions and start-ups, where, too often, it is seen here as the remuneration of shareholders, when it is anything but. But also from a European market that is growing less, thus generating less free cash flow.
The second graph, centred on the 600 largest listed European companies, clearly shows the totally discretionary nature of share buybacks, which reached their absolute and relative maximum in 2007. European companies, having doubts about the recurrence of the strong free cash flow they were generating at the time, preferred to use share buybacks rather than dividends as a means of returning this excess cash. Most of them then avoided having to cut their dividends with the reduction in free cash flow, some of which was quite transitory. All they had to do was reduce their share buybacks.
With the collaboration of Simon Gueguen, lecturer-researcher at CY Cergy Paris University
The banking crisis that began in 2008 (notably with the collapse of Lehman Brothers) has resulted, over several years, in a sharp reduction in bank loans granted to companies in a number of countries. The debt crisis in the eurozone in 2011 compounded this effect in many countries. In addition to weakening bank balance sheets, restrictions on bank credit affect non-financial companies, which are forced to abandon value-creating projects for lack of financing. A recent article shows that companies belonging to large groups use internal capital markets as a substitute for bank financing during crises.
For once, this article published in a major journal does not use US data, but Italian. Santioni et al were interested in Italian groups for several reasons. Firstly, the Italian economy is heavily dependent on these large groups: they account for a third of employees and 55% of total value added in industry and services. Secondly, unlike the Japanese model, which also has very powerful groups, banks are not directly affiliated with these groups. The effects identified in the article are therefore not the consequence of a direct link between the banks in crisis and the groups concerned. The analysis covers the period from 2004 to 2014. The first five years (2004 to 2008) correspond to the "non-crisis" period, and the next six (2009 to 2014) are the crisis years.
The first result concerns the probability of company survival (studied between 2006 and 2013). Santioni et al show that group membership increases this survival probability. Over the whole period, it is 50% for non-affiliated companies, 53% for those affiliated with a "small" group, and 61% for those affiliated with a large group. Above all, the importance of group affiliation is more pronounced during crisis years. Another notable effect is that the probability of survival is improved not only by the quality of the company's fundamentals before the crisis (which is obvious), but also by the quality of the fundamentals of the other companies in the group. Belonging to a strong group makes it easier to survive the crisis. This result is consistent with the argument put forward by Santioni et al that groups rely on internal capital markets to ensure the survival of their companies.
The second important result concerns the substitutability between domestic capital markets and bank credit. Santioni et al identify, within groups, capital flows from high cash flow but low investment opportunity companies to low cash flow and high opportunity companies. These flows are particularly marked for companies financed by banks in crisis.
It is as if the internal flows reflect more traditional capital markets. In crisis years, a €1 increase in cash flow for a group-affiliated company results in a 15-cent decrease in its internal market borrowing. Conversely, a €1 increase in cash flow for the group as a whole translates into an increase in internal flows to the company (admittedly modest, of the order of 2 cents). In times of crisis, therefore, groups tend to use internal capital markets, which operate on the basis of supply and demand and are a (partial) substitute for bank credit.
This article contributes to the academic literature on internal capital markets, highlighting their role in financing companies during crisis periods. It also opens the door to further research on the use of these resources, in particular the consequences of group membership on investments during a banking crisis.
 R. Santioni, F. Schiantarelli and P.E. Strahan, "Internal capital markets in times of crisis: the benefit of group affiliation," Review of Finance, November 2020, vol. 24-4, pp. 773-811.
 Groups defined as "small" by Santioni et al are those with fewer than 50 employees and less than 10 million euros in sales and assets; they are therefore very small groups.
I just read the following news: "Amazon has agreed to buy MGM for $8,45 bn, including debt. I'm not comfortable with "including debt": is the $8.45bn the entreprise value or the equity value?
It is not only under the influence of investment bankers who want to inflate the amounts of the transactions in which they participate that the practice is increasingly to give the amount of the transaction as the entreprise value, i.e. the value of the operating assets, that is to say here including net financial and banking debt.
Of course, this is not the amount that the company will pay when the transaction is closed, which is the amount paid for the shares, but this including debt amount is not uninteresting either, because sooner or later the debt of the acquired company will have to be repaid. Moreover, most often this debt is refinanced when the transaction is finalised, either because covenants make it payable in the event of a change of control, or because the acquirer does not find it to his liking (rate, residual term, covenants) and repays it with its cash or with a new loan.
Given that dividends payments are wealth-neutral, can we say that investment strategies aimed at high dividend yields are therefore meaningless.
No, we cannot say this for two reasons:
1 / the market is not always efficient and it can go through phases where dividend paying companies are undervalued because they have lower growth which is then little appreciated, and phases where they are on the contrary overvalued because investors appreciate their lower risks of value fluctuation due to their high dividends in a market where investors are brooding. Some investors try to detect the different phases and anticipate them in order to profit from a change of phase.
2/ some investors like high dividend stocks because it corresponds well to their risk profile (low) and their need for liquidity to meet the needs of everyday life (e.g. retirees), without knowing or being aware that it is enough to sell a few shares of a company that does not pay dividends to obtain the same amount of liquidity. But they then would have the impression of eating the capital, forgetting the appreciation of the share price in the long term which reconstitutes the capital for growing companies that do not pay dividends. Behavioral finance analyzes this type of behavior.
How to treat in a DCF calculation for a company whose free cash flows are negative, a capital increase that recapitalizes it?
In a DCF, we only take into account the free cash flows generated by the operating assets. A recapitalization through a capital increase to pay off financial debts is therefore out of place. Once the entreprise value has been established by discounting free cash flows, the amount of net bank and financial debt and similar items is deducted to obtain the equity value. It is at this level that the recapitalization will take place. You will have less net bank and financial debt and more shares in circulation. Indeed, if the company has made between the last known date for its debt, for example December 31, 2020 and today July 27, 2021, a capital increase, it is necessary to take this into account by reducing the net bank and financial debt as of December 31, 2020 in this example by the amount of the capital increase, and by increasing the number of shares by the number of new shares created since December 31, 2020.
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Sic transit gloria mundi
Once upon a time in the 1990s, there was a listed group (Poliet), active in the distribution of building materials (Point P), the manufacture of building materials (Weber and Broutin), controlling a large cement producer and holding 100% control of a nugget of industrial joinery, Lapeyre.
As its share price was far from reflecting the value of its assets, Poliet decided to float Lapeyre on the stock exchange, and this was the first time in France that the technique of book building was used to do so. It was a huge success thanks to Lapeyre's qualities at the time: strong growth, high profitability, high market share: the L'Oréal of industrial joinery!
A few weeks ago, Saint Gobain, which acquired control of Poliet in 1996, sold Lapeyre to Mutares, a fund specialising in the recovery of companies in serious difficulty, for a negative price of €243 million, i.e. about three times the annual loss. Mutares will thus find enough money in Lapeyre's coffers to finance a recovery plan, and Saint Gobain, which has not succeeded in turning it around, is making an ultimate investment in Lapeyre with a payback of 3 years, which is not something you find easily nowadays.
M6 -TF1 or the triumph of margins over sales.
The time is long gone when a minister of communication declared that the "little channel that's going up" (M6's slogan at the time) was "the channel that's too much in the audiovisual landscape"! If the M6-TF1 merger is approved by the competition authorities, it will be a triumph for M6 and its teams, led since 1986 by an unchanged management team (Nicolas de Tavernost and Thomas Valentin). With only 60% of TF1's revenues, M6 has more than three times the operating income of its competitor. Where TF1 has an operating margin of 5%, M6 is at . . . 30 %.
No wonder that M6 is worth more than €2 bn on the stock market, while TF1 is worth less than €2 bn despite having twice the audience of M6. It is also not surprising that TF1's share price rose more than M6's (7% vs. 4%) when a merger between the two was announced.
Finally, it is not surprising that the future leader of the merged group will be the man who does not like unnecessary expenses. Hats off to Mr de Tavernost, CEO of M6.
The IPO of PHE
Better known under the name of one of its main brands, Autodistribution, PHE, a distributor of car parts in Europe, is under LBO and is floated on the Stock Exchange, if all goes well, to raise in a few days a minimum of €450 million through a capital increase, which will enable it to reduce its debt. Indeed, with a ratio of bank and net financial debt to EBITDA of 4.8, a company cannot go public because, if its level of debt is perfectly suitable for an LBO fund, it is not to the taste of stock market investors, who are much more conservative from this point of view.
Therefore, the IPO of PHE takes the form of a primary operation which will allow to instantly reduce this debt ratio to 2.8, much more to the taste of stock market investors. Only the eventual greenshoe could take the form of a sale of existing shares.
This is an illustration of the unwritten, but very real, rule that it is difficult to go public with net debts of more than 3 times EBITDA.