By Jeffrey M. Singer and Ron Ferguson Stikeman Elliott LLP
The global IPO market, while trending downward from 2017’s banner year, remains healthy in 2018, with 1,000 deals raising more than $145.1 billion by the end of the third quarter, according to figures from consulting firm EY.
Yet, that’s only part of the story. What those numbers don’t take into consideration are the IPOs that never make it across the goal line because a company decided instead to sell, rather than go public.
In fact, more companies are opting to do a “dual-track dance,” when looking for an exit strategy. They’ll pursue an IPO, while at the same time entertain offers from private equity investors and strategic buyers. The numbers aren’t well tracked, partly because the sales processes usually involve private companies, but we are seeing heightened interest in dual-track processes.
Ten years ago, such dual-track pursuits were more theoretical in nature and bordered on questions of what if? Today, we would argue, current market conditions are such that a dual-track process has now become a requisite for most management and investors of private companies seeking a liquidity event—assuming, of course, that the company is a credible candidate for pursuing an IPO in the first place.
In our experience, companies that successfully manoeuvre a dual-track exit come out further ahead, primarily because the strategy introduces an added element of competition and price tension into the deal mix, which maximizes both transaction values and terms.
It’s no surprise then that we have seen the use of a dual-track strategy grow in popularity.
ADVANTAGES TO A DUAL-TRACK EXIT
However, it’s not just valuations that make a dual-track strategy attractive. Key advantages to a dual-track strategy versus a single-track solution are as follows:
1. Improves pricing and deal terms
As mentioned above, the more parties vying for an asset, the greater the likelihood that you will improve pricing and deal terms. Pursuing both paths flushes out potential acquirors and creates price tension that produces a more robust competitive process in terms of the pricing of securities in the IPO and enhances the potential multiples and vendor-friendly deal terms in the sale of a business, particularly if an auction process is engaged at the same time. For example, knowing that there is a credible private equity or strategic buyer in the wings can increase an IPO valuation. By the same token, buyers may be willing to pay more or accept less favorable deal terms if they know they are going to lose a target to an IPO.
2. Increases transaction certainty
Pursuing a dual-track strategy increases the likelihood of a deal being completed. If an IPO goes south and an issuer is unable to access the capital markets in a timely manner—for example, because of delays involving securities’ regulators or underwriters’ objections—the sale track provides a viable alternative solution.
3. Lowers valuation uncertainty
Academic studies have pointed to the reduction in valuation uncertainty resulting from IPO filings as a major reason for the higher acquisition premiums typically attained through dual-tracking, noting that private targets with higher valuation uncertainty, such as low-profitability companies in research-intensive industries, are traditionally among the major users of the dual-track process.
4. Less impact on timetable
Moving forward simultaneously with an IPO and a sale process ensures alternative liquidity options without negatively impacting the transaction timetable in the event that one strategic alternative ceases to be available to an issuer./p>
5. Complementary strategy
The legal requirements of an IPO process and the preparation of a comprehensive disclosure document with the requisite financial information assists with, and can be complementary to, the M&A process. There are some synergies that can be attained in the due diligence process that will serve both the IPO requirements and the information memorandum that supports the sale process.
6. Protection of stakeholders
Pursuing a parallel process allows the issuer flexibility in ensuring that the desired treatment for employees, customers, suppliers, and other key stakeholders is achieved.
7. Better Efficiency
Being engaged in both processes imposes competitive and time discipline on the participants in each of an IPO and an M&A negotiated or controlled auction sale process.
8. Flexibility for unexpected events
A dual-track approach provides issuers the flexibility to switch to another course of action should any of a range of unexpected extraordinary events occur (for example, a CEO termination, inability to obtain an auditor’s report or to complete the requisite audited financial statements, deficiency in an expert report, inadequate funds to meet working capital requirements, etc.). Pursuing both an IPO and a sale process as part of an issuer’s exit strategy ensures that fewer issuers will be subjected to unilateral determinations not to proceed with a transaction in the late stages of a controlled auction process by a prospective bidder or an IPO transaction by a financing syndicate member.
However, a dual-track process is no cakewalk. We have identified four primary disadvantages when running a dual-track process.
1. Increased complexity
Running two deals increases the level of complexity involved in seeking a liquidity event. Managing relations with financial advisors, investments banks and potential suitors and securities regulators requires skillful execution and planning.
2. Executive exhaustion
Running an IPO sales process and the accompanying roadshow taxes management’s time and company resources. Adding a sales process and possible auction into the mix requires management commitment, flexibility and dexterity.
3. Exposing state secrets
Management has to be prepared to make sensitive confidential trade information available not only to securities regulators, but potential competitors. However, the sales process can be managed in a stealth manner so that some parties are excluded.
4. Increased cost
Running what is essentially two-deals will of course drive up costs. However, with proper project management and using a single legal team and financial advisor, those costs can be mitigated. As well, the potential premium that can be attained far outweighs the financial strappings associated with a dual-track strategy.
THE CAPITAL MARKET WILDCARD
There is also one wildcard always at play, often underestimated and not controllable—market conditions. They, as much as priorities will, dictate outcomes in a dual-track process.
Current market conditions are ideal for executing a dual-track strategy, and those companies choosing to do so are benefitting. The present cycle is clearly a seller’s market, and we are nearing the 10th year of an upward financial cycle.
In some instances, we have seen a narrowing in the valuation between what the public market is willing to place on a company versus a private buyer. In some circumstances, a private sale can actually garner a premium over what a public offering would render. Now, more than ever, market conditions need to be weighed when considering the viability of an IPO versus a sale.
So where are we in that market cycle? Have we peaked? That’s hard to say, and no one really knows for sure. Capital markets are robust, and every week we seem to test new market highs across many industry sectors.
POSITIVE ECONOMIC FACTORS
There is no shortage of positive factors favoring continued upside. They include:
Global statistics point to healthy and robust merger and acquisition markets. According to Thomson Reuters, worldwide deal making hit a record $3.3 trillion in the first nine months of 2018. It was an increase of 37% over the first nine months of 2017, and was the strongest first nine months since the firm began tracking deals in 1980.
Cross-border M&A saw its strongest performance since 2007. It accounted for 41% of activity. There were $1.3 trillion in cross-border deals during the first nine months, a 56% increase over the first nine months of 2017. Exit multiples were up in 8 of the 12 sectors. Simply put, the markets are humming.
Private capital flush
Private equity is reloading, as investors exit their current investments, and look to redeploy their capital. Meanwhile, new money continues to flow into the private equity space.
Bain Capital notes in its Global Private Equity 2018 report that private equity managers have raised more than $3 trillion in the past five years. Of the 38,000 deals globally in 2017, less than 10% involved private equity, leaving room for expansion. Bain says that the private equity industry is flush with capital and “dry powder” is on the rise, hitting $1.7 trillion at the end of 2017. There are now 7,775 private equity firms hunting for deals.
Investment research firm Prequin, which tracks institutional investors, notes that 57% allocate money to private equity. A further, 86% of Institutional Investors plan to maintain or increase their private equity investments and 44% see small- to mid-market buyout funds as presenting the best opportunity. Private equity now ranks as the second alternative asset class after real estate for institutional investors.
Valuations remain high
Bain Capital notes that prices are soaring. The average EBITDA purchase price multiple for leveraged buyouts rose to a historic high of 11.2 in 2017. As well, buyout-backed exits valued at $366 billion were strong, but still down from the peak of $464 billion in 2014, suggesting new highs could still be attained.
IPO markets robust
The IPO markets hit their highest level in 2017 since 2007. According to consulting firm EY, the first three quarters of 2018 produced 1,000 global IPOs, which raised $145.1 billion, a 9% increase in value year-over-year.
Business confidence is strong
Surveys show that business confidence remains high, so corporate buyers are likewise aggressive when it comes to strategic growth through acquisitions. Bain Capital found that strategic buyers continue to be the primary acquirer in the private equity markets, followed by sponsor-to-sponsor deals and then IPOs.
The economy is firing on all cylinders
Adding to all of this is that the economy is generally firing on all cylinders. Here at home, the Bank of Canada notes that the 2018 Summer Business Outlook Survey indicator reached near-record levels, driven by widespread business optimism, including:
- “Firms’ sales outlooks remain robust, supported by strong foreign and domestic demand, and improvements in some commodity prices.”
- “Investment intentions, while slightly weaker, are still buoyant, driven by sustained demand and intensifying capacity pressures.”
- “The employment indicator continues to trend upward, pointing to broad-based hiring plans across the country.”
- “Reports of pressures on production capacity and labour shortages are increasingly common, mostly outside the energy-producing regions.”
- “Most firms reported no change in credit conditions.”
NEGATIVE ECONOMIC FACTORS
Nonetheless, there are clouds on the horizon.
Economic cycle long in the tooth
The current bull market in US economic expansion dates back to the trough in June 2009, according to the US National Bureau of Economic Research. That makes it the second longest expansion cycle on record. If it continues through the second quarter of 2019, it will surpass the previous expansion of 120 months. A typical expansion from trough to peak since 1854 is 38.7 months, or 58.4 months since 1945. Accordingly, this expansion is getting long in the tooth.
Deal counts declining
Despite rosy M&A numbers, when you look past the eye-popping valuations, you will see that the number of deals is actually declining, despite strong competition among acquirors. Bain reports that private equity deal count has declined substantially since 2014, off 19% from the highwater mark set in the current economic cycle. Deal counts are also declining in the global M&A markets. In the first nine months of 2018, the number of deals was down by 10%. In Canada, deal value declined by 8%, while the number of deals declined just under 15% compared to the first nine months of 2017, according to Thomson Reuters.
Political and trade unrest
The growing threat of trade wars, the imposition of tariffs and uncertainty around the implications of the recently negotiated United-States-Mexico-Canada Agreement (USMCA) are also impacting market conditions.
Interest rates climbing
Interest rates continue to rise, with more hikes on the horizon, which is driving up the cost of capital and starting to squeeze debt-strapped Canadian consumers. In July, the Bank of Canada raised interest rates for the fourth time in a year. While the bank held fast in September, economists predict that interest rates will continue to rise and possibly pick up pace now that the USMCA has been negotiated.
Canadian tax reform lags the US. The U.S. Tax Cuts and Jobs Act has changed the competitive landscape in North America and eroded what was once a competitive advantage for Canadian companies.
SALE AND IPO VALUATIONS MERGE
One of the most important developments that we have seen emerging in the current economic cycle, as mentioned above, is that the valuation gap between the IPO and sale markets are narrowing. That provides a stronger impetus for companies to consider a dual-track strategy.
One of the factors narrowing the valuation gap between an IPO and a sale has been regulatory change in relation to disclosure in the IPO market.
Companies rely on forecasts and other forward-looking information to obtain a high public market valuation. Not long ago, five-year outlooks were customary and were used in corporate roadshows to support planned IPOs.
In July 2018, the Canadian Securities Administrators issued Staff Notice 51-355 on continuous disclosure review covering fiscal years ending March 31, 2018 and 2017. In it, the CSA tightened the noose further on forward looking information (FLI).
The net effect is that valuations that may be available in an IPO process, may also now be available in a negotiated or controlled sales auction.
FACTORS LEVELLING THE DUAL-TRACK PLAYING FIELD
There are other capital market developments that are levelling the field between IPOs and negotiated sales that support pursuing a dual-track strategy.
For example, deal factors are shifting. Not only has the valuation delta eroded, but the tension provided by the dual-track process results in many private deals now being structured to reflect public-style deals. Sellers can now negotiate with strategic and private equity buyers to eliminate things like holdback, earns outs and indemnities or use insurance to offload risk around representations and warranties so that they don’t survive the closing, making a sales process much more attractive.
UNDERSTANDING PRIORITIES DICTATES BEST EXIT OPTION
Once you take the market conditions and shifting deal factors into consideration, it’s time to assess and rank corporate objectives and priorities. Balancing these objectives is no easy task. There is no one-size-fits-all template.
For example, both a sale and IPO can address the multiple reasons why a company is seeking a liquidity event. They both unlock value, provide greater access to growth capital at more favorable cost, provide enhanced brand awareness, improve governance, pave the path to succession, and meet the needs of stakeholders and investors. However, each company has different factors and priorities at play that stakeholders must address along the way.
Interestingly, though, as with most commercial arrangements, value tends to be—but isn’t always—the primary priority or gating tool that drives the process.
The owner-manager’s team may seek to continue operating the company, but key investors wish to move on. The investor likely values price as a priority, while the management team will be less concerned about price and more concerned about the path forward.
Priorities are very specific to each company and each deal, and they will dictate the best option. There are five common priorities that companies need to address.
One of the first assessments is timeline. Those with shorter-term concerns may be worried about the effect of a market correction. Are we in the 7th inning or extra innings at this point? Others will have the luxury to ride out any market corrections. Timeline considerations are compounded by differing priorities among the ownership group. For example, private shareholders who want to exit their investment will often have a different viewpoint on timeline than a management group.
A second priority to consider is liquidity and immediacy. Many private capital owned or backed companies may prefer a sale as it permits the greater or immediate liquidity alternative. IPOs do not permit for an immediate full exit and carry restrictions on future share sales. There can also be lock-up or standstill agreements that are unattractive to shareholders seeking a clean exit.
3. Controlling your destiny
The third priority relates to control and being a master of your own destiny. An IPO, for example, provides management greater autonomy, in contrast to working for another private equity firm partner or as a business unit of a larger organization. That is especially true if management is in it for the longer term.
4. Riding the upside
Fourth is whether riding the upside potential is an acceptable risk. Companies with a stronger management ownership base may prefer the IPO, as it gives them and their staff continued upside. The downside is that a market correction could wipe out the value of sponsors’ retained interests, options and employee share ownership incentives.
5. Succession planning
If it’s a family-owned private entity and succession to the next generation is imperative, then that will impact both how an IPO share class is structured, as well as the type of sale that would be negotiated.
THE FINAL SAY
Running both processes in parallel preserves maximum optionality, creates a competitive marketplace to maximize valuation, permits clients to pivot with changing market conditions, and creates the greatest opportunity to achieve the optimal deal.