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Flooded with money, capital markets could present CFOs with many answers to the perpetual question of where to get cash.
Vincent Ryan, CFO Magazine
December 1, 2010
Calistoga Pharmaceuticals has a new drug for cancer and inflammatory diseases that is currently in Phase 2 clinical testing, but the company's $96 million in venture capital won't last through the registration and commercialization processes.
Fortunately for Calistoga, finding more cash will be anything but a trial. The company can tap private equity again, borrow from a commercial bank or nonbank lender, or even partner with a large biotech company. "Whether we [raise capital] in one shot in 2011 or [in stages] will be determined by the state of the overall markets," says CFO Andrew Guggenhime. In any event, Calistoga will have its pick of options.
Welcome back to the luxury of choice. Low interest rates, investment-capital overhangs, and hunger for yield mean many CFOs will enter 2011 with a surfeit of capital-raising opportunities. Capital markets have recovered remarkably since the recession. Debt, for example, is dirt cheap. Wal-Mart's sale of three- and five-year bonds last October garnered the lowest-recorded coupon for U.S. investment-grade since 1970. "This is kind of a historic time; what a great time to be a borrower," says Varun Bedi, a principal at Tenex Capital Management. "The average A-grade, 20-year bond is at rates we haven't seen since the 1960s."
Not to be outdone, equity markets have also rolled out the red carpet. Global volume of initial public offerings totaled $147 billion in the first three quarters of this year, the strongest nine months for IPOs since 2007, according to Thomson Reuters. On a smaller scale, private investments in public equity have picked up in both size and number — as of October, $50.8 billion was invested in 1,073 deals.
"I think 2011 is going to be a great year in the equity markets," says David Gruber, managing director of KeyBanc Capital Markets. While not as many dollars have been raised in [the United States] in 2010, the market is healthier — deals are trading better and the equity raising is for strategic purposes, he says. Private sources of both equity and debt have also returned. Hedge funds are corralling billions from wealthy individuals, and insurance companies are eager to match-fund their long-term liabilities.
Not that markets will be impervious to shocks from the outside, especially as the U.S. government tweaks monetary policy to energize consumer and business spending and a new Congress changes the political climate. A continuing weak U.S. dollar, for example, could push even more fixed-income investors to emerging and other offshore markets. Or, if inflation expectations rise, corporate bond sales could be scotched.
So it wouldn't be wise for CFOs to write their capital-raising plans in ink, or assume that fund-raising vehicles will be available when the right investment appears. But, barring major dislocations, the prognosis for 2011 is good.
That said, in the IPO market, investors continue to be picky. IPOs from Asian companies performed the best in the third quarter — 5 of the top 10 debuts overall were American Depository Receipt listings, according to Renaissance Capital. The shares of India-based online travel outfit MakeMyTrip, for example, climbed 89% on the first day and rose another 47% in aftermarket trading. But IPO investors have not been "indiscriminate," says Renaissance. Shares of ShangPharma Corp., a China-based biotech research-and-development outsourcing firm, fell 7% in their first week.
Money is available, but "it's very selective," says KeyBanc's Gruber. A buyers' market caused two kinds of IPOs to backfire in 2009 and early 2010. The first were attempts at raising blind pools of capital to buy distressed assets; the second were financial sponsor-backed deals that attempted to sell large chunks of equity at full valuation.
While so-called blank-check companies (created for the purpose of buying other companies) have staged a comeback, private-equity firms have to reset expectations. "The rule of thumb is an IPO discount of 10% to 15% versus the comp group," says Gruber, "but financial sponsors try to sell through that discount. In a buyers' market, that doesn't work."
On the other hand, investors will open their wallets for companies that deploy equity capital for growth, says Gruber. Companies like Vibrant, a provider of contextual advertising for Websites, could benefit. Vibrant is generating cash, boasts earnings growth in the mid-teens, has no maturing debt, and self-funds its working capital. A June launch seems likely. "We don't need to raise capital to execute on our strategic plan," says Vibrant CFO Jeff Babka, who took NeuStar public in 2005. "But we could advance it — through an acquisition — if we had additional capital on our balance sheet."
Vibrant is establishing a Sarbanes-Oxley compliance program, honing its forecasting process to provide public market guidance, and working with auditors to clearly understand accounting and financial-reporting requirements for its S-1 filing and life as a public company. "If the market isn't open or we decide to hold off, it's not as if we are wasting our time doing this. It will all strengthen our business," Babka says.
While Babka hopes for a home run, he is realistic. "You have to put up some pretty significant metrics," he says. "It's also incumbent upon the management team to create a sustainable business model and ensure there's no subsequent crisis that could leave investors holding the bag."
As merger-and-acquisition activity heats up, Gruber expects a robust market for secondary offerings, especially for management teams that craft a good story around the use of proceeds. Post "flash-crash," though, reducing exposure to market risk will be a top priority. Smart companies will limit the hit to trading prices by using overnight trades (launching at market close and pricing before the following morning's open) or one-day offerings, which give management a day to sell the merits of the deal to the buy side, including new investors. The one-day structure exposes shares to market risk, but "when you have a good use of proceeds, the stock tends to hold in very well and the pricing is as tight versus an overnight," Gruber says.
Going Long on Debt
Tapping shareholders is not an option for CFO Alexey Kornya of Moscow-based, NYSE-listed Mobile Telesystems. Raising funds in U.S. dollars to finance the build-out of Mobile Telesystems's 3G infrastructure doesn't make sense when the Russian ruble is strong and 70% of the company's liabilities are domestic.
But the bond markets have been too good anyway. Mobile Telesystems issued a 10-year, euro-denominated bond in May and was planning sales in November equivalent to $819 million with 7-year and 10-year maturities. "Institutional investors are reaching for a longer tenure to get a reasonable coupon," Kornya says. "If a company has stable cash flows, there will be low volatility, and [if necessary] the bonds can be bought back from the market at a good price."
The bond market could remain healthy for another two years, since spikes in corporate rates run in five-year cycles, says Tenex Capital Management's Bedi. "There will be an increasing emphasis on quality companies, and those guys are going to be given incredibly preferential rates."
Smaller middle-market companies that don't need at least $300 million of debt may find little comfort in the successes of a Mobile Telesystems. But private-placement debt can provide a capital structure that resembles a large company's. This long-term fixed-rate credit is privately negotiated and distributed, has maturities of 5 to 20 years, and is held to maturity by investors, generally insurance companies and pension plans. The market usually does $30 billion to $50 billion a year in issuance.
"We're having one of our most active years ever," says Allen Weaver, senior managing director at Prudential Capital Group, a provider of long-term private capital.
Ninety percent of the dollars Prudential Capital invests for itself and others are investment-grade. The borrowers are generally industrial or service companies with good earnings histories, low volatility of earnings, and solid cash flows, says Weaver. The borrowing rates usually track the public market, with some premium because the private market is fairly illiquid.
While privately placed debt doesn't replace a bank facility, it diversifies the funding base and lessens dependence on banks, Weaver says. There is also a "confidentiality advantage" if the borrower needs to fund an M&A deal stealthily.
Of course, it's one thing to have a solid roster of capital-raising options and another to take advantage of it. Experts say that capital-building is still essential to good risk management: middle-market companies that foresee bumps in earnings should be in capital-raising mode continually next year, says Bedi, and think of their lenders as even more important than their equity holders. "They are going to keep you solvent," he says.
Large companies, on the other hand, should aggressively lengthen their maturities. Counsels Bedi: "Even if you're a great company, you never know when the rainy day might come, so you should have too much capital, not too little."
Vincent Ryan is senior editor for capital markets at CFO.
Turning the IPO on Its Head
Any transaction with the words reverse and shell in its description can give CFOs the willies. But through the first 10 months of 2010, close to 200 companies had entered the equity markets via a technique known as the "reverse merger."
A reverse merger is the bargain-basement way to go public: a private company sells itself to a publicly traded "shell" company and then takes control of the shell. The transaction is usually done in conjunction with an infusion of money from private investors. The private company's owners end up holding as much as 95% of the shell company.
Reverse mergers don't supplant traditional initial public offerings. They typically raise only $3 million to $5 million. But the private company gets a public listing without paying hefty underwriting fees.
Many of these transactions get done through the over-the-counter securities market, so the newly public company has time to "season itself" before the stricter corporate-governance regulations of large exchanges, says David Bukzin, a founding partner of accounting firm Marcum LLP.
Reverse mergers could be an excellent strategy for companies "that are in industries Wall Street typically loves or that want common stock for acquisitions," Bukzin says. Financial sponsors also use them to increase the liquidity of their investments.
A key to such transactions is to raise enough capital to get to the next phase of the company's growth plan, says Bukzin. If the market sees the potential, the price and liquidity of the stock improve and a larger share offering and an uplisting to Nasdaq or the NYSE become possible.
Still, taking over a failed company (which is what many shell companies are) is filled with potential minefields. The shell company may come with pending litigation, for instance, or a damaged balance sheet. That could take months to clean up, adding expenses the reverse merger was supposed to avoid. — V.R.