John Kolz
Welcome to the US Equity Capital Markets roundtable from RBC. Our goal with this roundtable is to try to offer some timely thoughts and insights to both corporate clients and investing clients from our capital markets professionals. I'm your host, John Kolz, Head of US Equity Capital Markets here at RBC. And today, I'm joined by Jesse Chasse and Chip Wadsworth, who together, look after our Tech Equity Capital Markets business.
Jesse, Chip. Thanks for joining us,
Jesse Chasse
Good to be here.
Chip Wadsworth
John. Thanks for having us. Looking forward to the conversation.
John Kolz
We sit here today at the end of our two day tech, internet media and telecom conference in New York City, a great forum where I think we had 500 plus investors over 100 companies, both public and private. And it's a perfect time for us to sit down and reflect on some of what we heard, as we finish up what is a very wacky 2023 by any way you measure it, and in turn our attention to ‘24. So with that wind up, maybe Jesse, what have you heard what have been the main themes, both from corporates and from investors? And just any observations as we finish out the conference?
Jesse Chasse
You know, from investors is, as they look forward to 2024. And we happen to be at a at a time in the calendar, where investors are thinking about how are they going to deploy capital? How are they going to put money to work next year, we continue to hear from investors that it is very much a sort of back to basics approach to investing. And so what that means, in terms of what investors are looking for, I think there's a lot more scrutiny around sort of the key investment themes that they've been focused on historically. So you know, number one is what's your TAM? There's a lot more scrutiny on sort of the scope of your TAM and the durability of growth that underlies that TAM. There's a lot more focus on quality of revenue, right? We've all heard the tack back to efficiency and margins, not just growth. And with that a big focus on unit economics, I think there's a desire to invest in businesses that are mission critical, that offer a true ROI, to their clients. Again, a big focus on moats, a big focus on platform businesses that are category leaders. Because there's sort of a market of winners and losers at the moment, I think there's a big desire to deploy capital towards the winners. And then the obligatory comment around AI. I think investors broadly are still trying to get organized around how they want to invest behind AI. But at the moment, there's a sort of desire to look through the market and figure out who are the AI winners? And who are the AI losers in deploy capital against that theme, in more of an index approach at the moment, just because there's still a lot of uncertainty around who the actual winners and losers are going to be around that theme.
Chip Wadsworth
I think the commentary is very much on the other side of the conversation around what investors are looking for how companies have actually responded to that question, I think, in many ways, the CEOs and CFOs that we spoke to over the course last 48 hours here, and the folks that we've connected with over the course last weeks and months, they've gotten the message. So, for all intensive purposes, whether it is some of the largest, most important public companies, or many of the private businesses that we're interacting with, they have heard this back to basics theme, they have shifted the way that they think about not just building their business, but doing it in a growth oriented profitable mindset. And I think that that component is we look into 2024. Whether it’s, again, investors putting their capital to work with public opportunities, or when that IPO class of 24 actually comes to market, finding the best opportunities out of that group. They're going to be really defined by that back to basics mentality. And fortunately I think the CEOs and CFOs they get it they've taken taking that message to heart and are starting to act on it.
John Kolz
Well to that point, the private companies that were here, what was their goal? Many of them, I think told us hey, I'm not going public anytime soon. So what? What were they trying to achieve? And you think they did that as what did we hear from him, Jesse?
Jesse Chasse
Yeah, look, I think the core goal of many of the private companies was just really to understand what are going to be the key battlegrounds when I come public, right? As I think about my business today and my financial profile today, and managing towards my IPO, whether it's 12 months, 24 months away. If I understand, what am I solving for? It's a lot easier to set up the trajectory towards IPO such that you have the financial profile that investors are most focused on. But that you also understand where the key battlegrounds are. So as you develop your investment narrative, you sort of know how to front run, what some of the skepticism might be, because I think, broadly, private companies understand that investors are going to be much more skeptical this cycle than they were in the previous cycle. So the more that you can do to understand where that skepticism lies ahead of time, you can craft an investment narrative to attack that head on versus being defensive and reactionary.
Chip Wadsworth
Yeah, there's a there's definitely the element of, “how is my business going to be perceived by these public investors” and making sure that they're ready for those battleground questions. But there's also an element of just relationship building. And I think the astute management teams realize that IPO windows open and close, probably more so than we want them to. But when that IPO market is reopened, it's as much a relationship sale as it is a sale in and around what the fundamentals of your business look like. So the folks that we were talking to you today and yesterday, for them, it was just hey, let's go meet some investors and make sure that they know who we are. And when it comes down to that IPO roadshow, we've actually gotten a warm call instead of a cold call.
John Kolz
One of the things that the three of us talk about quite a bit is that the investors who were the key investors in the previous wave of tech IPOs, may not actually be the same investors in the coming wave, that there are, certainly some of the household names are going to matter a lot, but that there's a set of investors that are very important that are very much the ones to build relationships right now, with that will matter the names. Some of the names will be the same, but for sure, some will be different.
Chip Wadsworth
In some ways. It's amazing how IPOs used to get done, right? If you think about back in the day, you would do all this work privately, you'd file a prospectus, you'd launch your IPO roadshow, you do two weeks, plus or minus, with a bunch of investors that would get 45 minutes with you. They then do some work with an analyst and sales team; they’d make a decision. Now we have four or 5, 6, 7 bites at the apple to develop that dialogue and develop the list of the right investors at the end of the day for folks.
John Kolz
Right and at the same point, though, when you take the most recent IPOs, we'd all probably conclude there was some process that was broken, right? The fact that while there were maybe many more interactions, or should have been many more interactions, the allocation playbook seemed to be a little bit the same before heavily concentrated, heavily defensive oriented, and really not courting what we might argue are the right investors for today.
Jesse Chasse
The question on whether or whether or not it was a failure is really tied to what their objectives were, right? There's a lot of good things and positive signs about those IPOs. I mean, they all saw really significant demand, and they all priced at very healthy multiples. Now, the disappointing part has been how they've traded in the aftermarket. And so, you know, one of the things we always talk to when we advise our clients is any IPO process has to start with a conversation around what are your core goals and objectives, right? If your core goals and objectives are to really maximize fair value at IPO? There's a playbook for that. If your core goals and objectives are to set up a stock that trades well and creates valuable for pre IPO holders, but also new investors over time, well, there's a playbook for that too. And to some extent, the three IPOs that priced were seemingly over engineered to solve exclusively for one problem, which is how do I maximize every dollar at IPO? Look, and I think the reason for that was there was a lot of concern that there was going to be a massive first mover discount, or a first mover disadvantage paid for the first wave of IPOs. That's not at all what happened. But what did happen is investors who bought those IPOs haven't made money, right? And that has long term knock on implications for management teams as well, right? One of the things that happens when an IPO is priced to perfection is there's a broad expectation that as those companies report over time, they're going to blow out their earnings.
John Kolz
Which certainly did not happen, right, in those first quarters out of the box…
Jesse Chasse
Which is why you saw a massive reaction to the downside to quarters that maybe even on a headline level, we're in line. And look that creates long term issues for a company. And, you know, we always tell companies, you've really got to execute out of the gates, because you're establishing your credibility in the public markets. And those type of challenges can follow you over time. And so again, we think you really ought to start with a conversation around what your objectives are, but we encourage our clients to be long term focused, because you know, one of our favorite adages is the IPO is the wedding. But don't forget about the marriage.
Chip Wadsworth
So the advice process is step one, I think there's also an iterative nature to that decision making. It doesn't just happen when you go pitch the IPO. There's, I think, an elongated discussion that you have with all parties to make sure that everybody's on the same page.
John Kolz
Yeah, that's, that's a really great point, especially now, when the time horizons for some of the investors are much longer than they thought there has been valuation changes. There's new entrants who have different horizons, different expectations of valuation, it makes the simple point of, “what are our goals?” What are you what are your telling clients in absence of, or in avoiding the question of when does the IPO market reopen?
Chip Wadsworth
The first thing that we are highlighting is the fact that the buy side is open, they want to have that initial conversation, they want to have multiple conversations. The second thing that we highlight is that there are data points out there that indicate there's going to be some movement. Those data points are things like private companies hosting analyst days, right? So these are businesses that while they might not be on file formally, they're doing all the right things as relates to developing the relationships, not just with potential buyers, but also with a group of potential investors and underwriters. So that's another piece to it. And then you know, we are very focused on what does the RFP cycle look like. And while the RFPs are not jumping over the transom at this point, we're definitely seeing the first steps in sponsor backed businesses having formal dual track conversations with us around M&A versus IPO. And we're also starting to see some of those either bootstrapped businesses or venture backed businesses have a real formalized bake off process. So with all those in place, you can actually say in six months, there should be some additional activity, some additional flow. But it's going to take a lot of work to get us there.
Jesse Chasse
As you think about the hurdles to the reopening of the IPO market, I think number one is demand being there. And as Chip said, we do think that there's demand for these IPOs. Number two has been sort of the bid ask spread on valuation closing. And we do think there's a lot of work that's been done around that, and there will be some capitulation on that valuation. You know, the last three IPOs done was a down round, I think there's a lot less skepticism around, you know, down round IPOs. So I think a lot of that work has been done. Another is just, you know, the need to go public. So a lot of these private companies raised a lot of capital in the last cycle, and thus had enough cash on the balance sheet, where they have the ability to be patient. We're starting to work through that. So there's going to be some companies that are sort of forced in the market as a means to get cash. But the biggest hurdle, as it relates to the conversations that we're having with management teams right now is just this ability to forecast their businesses, right? They spent all of last year taking down burn, right? So that's a headwind to growth. They spent all this year dealing with enterprise optimization and macro headwinds, which is another headwind to growth. And so if Chip, and I show up and tell you “Look, you've got to be debt on for your first eight to 12 quarters out of the gates,” that seems to be a challenge at the moment. And so as we continue to work our way through, you know, what many are calling a b2b or an enterprise recession and have a little bit more stability and around how companies are able to sort of forecast growth. I think that's going to be the final hurdle for the broad reopening of the IPO market.
Chip Wadsworth
And jut one other quick addition to that is, while the IPO market is playing itself out, the overall liquidity dynamic for many of these sponsors, not necessarily for venture capitalist because they distribute shares, but for the sponsor community. You know, if you look at 2023, one of the major themes is just DPI, right distribution to paid in capital, and how that cycle shakes out, is going to also have a an impact on what this IPO calendar, and cadence looks like going into next year. We've seen a significant increase in sponsor backed follow-ons, sponsor backed registered blocks, sponsor backed unregistered blocks in the last year. At the beginning of the year, those were pricing very wide, right? Sponsors were going into the marketplace, they weren't quite getting the terms they wanted. But they were getting the liquidity that they needed to keep the DPI going. Fortunately, those terms have shifted to the positive for the, for the PEP community. And I think in that context, having that that flywheel working in the right direction, the right flow, is only going to enhance our opportunity to take some of these next businesses out as we go into 2024.
John Kolz
Yeah, I totally agree with that. I think sometimes we lose sight of the fact that 40 plus percent of all equity capital markets dollars, or volume comes from private equity, maybe less so in tech, but I think they are going to drive us out of the doldrums of issuance. And next year, we head into an election year and the rhetoric around that will start well in advance of the conventions, which I believe are in July and August. And so we're gonna have to deal with that and sort of the discussion of, do we need to work our way around or thread timelines around those type of things? In the meantime, what has been very active has been the following market, in particular, the block market and as we expected, driven in large part by private equity, again, some of the venture community as well, but a recent rally in the market producing just like you said, Chip, DPI, a sponsor who says, I can take a few chips off the table at a better price than I’ve seen in quite a while, coming off an earning season that was generally very strong. So there's been a resurgence there. Do we Jesse, do we think that continues through the remainder of 23 and into 24? How do you see that?
Jesse Chasse
Absolutely. Look, I think public sponsor own companies are for sale. I think you're going to continue to see really in every earnings window sponsors continue to monetize those assets. And I just think broadly, the secondary market will continue to dominate issuance across equity capital markets. And then the other trend we've seen that's worth mentioning is on the primary side, you know, a lot of companies don't like their stock. They're broadly well capitalized. So we haven't seen a lot of equity issuance on the primary side. But we have seen a lot more activity in the converts market this year, right? And so, you know, with rates being where they are, as you think about, you know, a tool to manage cost of capital, to sell equity at a premium to maybe even buy back some of those shares that you feel are undervalued, the converts market has been another bright spot. And I think that trend will only continue into next year as well.
John Kolz
Yeah, yeah, on convertibles, we're up over 400% in convert revenue this year, it's off a very low base. With volumes up dramatically. We continue to see that as an important piece of the of the toolkit for existing companies. And one of the things that was a tool used in times past in reopening’s of IPO market is thinking about do you put a mandatory or convert preferred alongside an IPO to add some yield in with the with the common stock offering. Chip, what do you when you look at whether that's follow-ons and blocks and converts? Or even maybe derivatives and the like, what do you what do you see on the horizon for client conversations?
Chip Wadsworth
Yeah, I think there are a couple additional pieces to the puzzle, you mentioned derivatives, if anything, you know, the sponsor community that we interact with daily, they look at finding that that path to dpi that path to liquidity, not just through the regular way, equity markets register block, follow on however you define it, they're using much more creative, much more forward thinking tools, margin loans, you know, call options, etc., to put themselves in a position to not just find the liquidity, return it to LPs, in some instances use that liquidity to fund M&A for some of their portfolio businesses, but effectively take the next step and put themselves in a spot where it's not just a straight sell down. But there are other tools at their disposal to create that liquidity. One of the biggest points of concern from corporates that we spoke to, was just around liquidity in their stock. So they want to see the sponsors take the next step. They want to see that incremental liquidity step up because it allows for all the public investors to get in a better position than they currently are, that that element I think, is going to be a real important component to success for a lot of these businesses in 2024.
John Kolz
It’s true sometimes I think there's a skepticism between corporates and investors as to the need for and the importance of liquidity and Jesse we had a client meeting this morning where the CEO said, “I view it as an obligation of my company to continue to enhance liquidity of the stock.”
Chip Wadsworth
100%
John Kolz
It's refreshing or reinforcing I should say to hear corporate say that obviously we know investors care dearly about liquidity.
Chip Wadsworth
One other piece I think we are all watching the M&A trade, right? So there is a there's a very slow burn to liquidity for many sponsors and others and putting blocks and followings out there but there could also be the you know, the engaged smart, large M&A transaction that comes around and cleans up not just the liquidity profile but the you know, the company itself that that could be a big piece of 2024 as well.
John Kolz
Let's pull on that a little further. All companies who are approaching the IPO markets are in essence running a duel if not a tri-track at this point. And investors will have assumed if you're going public you probably considered selling the company as well. Do you agree with that mentality? You think investors truly believe that a dual track has been run? And do you think that's healthy for the reopening of the IPO market?
Jesse Chasse
Every investor we speak to, and this isn't new, has both a desire and an obligation to maximize value for their investments. And as the cycle sort of moves and progresses, there's value arbitrage across different products, we are in a time during 2021, where that our value arbitrage accrued massively to the public markets. And during that time, you know, things were also dual track, but it was dual track of SPAC versus IPO versus direct listing. And so as advisors were always forced to evaluate what is the tool, product or market that creates the best outcome for investors. And similarly, in this cycle, there might be more value to exiting a position through M&A and sort of cashing out up front versus monetizing over time in the public markets, particularly if there's not a big belief that there's going to be massive value appreciation, at least in the near term in the public markets. And so I think it's absolutely a healthy part of the dialogue, and one as advisors, that that we're very comfortable with having.
John Kolz
One of the guideposts that I know we all look at to try to gauge some of these unanswerable questions are, what's the activity level in the private equity community, i.e., we see a lot of private equity companies saying to us,” Hey, we are open not only for buyouts, but we're open for minority investments, we want to be in that business.” That's one, and of course, traditional venture capital activity, what are the VCs doing? And how are they still putting money to work?
Chip Wadsworth
There are three areas that it feels like are the focal points, there's first and foremost, just the group of companies in which VCs have already invested, they feel very strongly about, they are doubling tripling down on those assets. They are doing everything they think they can, from a structural perspective to put dollars to work without impairing value. But, for all intensive purposes, there's a select group of businesses in their portfolios that they're going to work with. The second piece is, and Jesse alluded to this, clearly, the AI element to where the future lies is a really, really important theme and trend. And then look, I think the broader context of what public investors have highlighted, which is that efficient growth model, the profitable growth model, that is absolutely center stage for the VC community that we're talking to, they're trying to find those businesses, where there's a capital efficient model that is in place, it's typically a founder that has found a niche, a specific vertical, that they are just attacking with all force, but really doing it in an efficient manner with great KPIs and ultimately, a path to what you're gonna consider to be long-term success.
Jesse Chasse
So, we've sort of looked back over time across the software universe is a is a good sample set to highlight this question on growth versus profitability. And at the peak of the cycle, if you run a multivariate regression of forward revenue growth, and forward EBIT to margin relative to multiple, you were paid eight times for a point of growth that you are for a point of margin. So we're at the point in the cycle now where you're still paid a premium for incremental point of growth than what you are for an incremental point of margin. But that premium now is only 1.3 times versus eight times at the peak. So we're still in a market that values growth over profitability. But it's certainly not anywhere near where we were at the peak of the cycle. And then you also see a shift in those correlations, whereby there's this idea that you need to be in control of your own destiny. So there's a line in the sand, which is that once you're profitable, the correlations to growth go way up. But the market wants you to at least be profitable so that you have the ability to control your own destiny.
Chip Wadsworth
Just to transition a little bit. This is a TIMT conference, right? So it is not just tech, we did host our comms infrastructure conference back in Chicago in September. And in many ways, that was an explosion of interest. And the main focal point in that that discussion was in and around the data center space. over the course of the next two to three years are going to be a really important element to the TMT IPO universe. Right? It's a group of companies that they're probably 10 globally, all have either been public or have invested in have folks that are private equity investors and sponsors that because of the way those business models are built, they are very capital consumptive. The sponsors need to continue to fund those businesses and they are so large that the likely path for these businesses got to be the public side of the equation.
John Kolz
I think one thing that we and investors can all agree on is that the overused words of the picks and shovels to enable AI which are datacenters, and obviously the NVIDIA of the world and others that is a fertile ground to invest without having to necessarily declare who the winner is.
Jesse Chasse
It’s generating revenue today, right?
John Kolz
Thanks to everyone for joining us for the RBC equity capital markets roundtable. We look forward to having you join us again for the next episode, where we will evaluate predictions and then tackle some of the latest issues in the ever changing ECM landscape. If you have any questions in the meantime, please feel free to reach out to me Jesse or chip or any member of the RBC equity capital markets team. Thank you and see you next time.