As companies stay private for longer, interest has been growing in strategies that straddle both the private and public arenas. We speak to Neuberger Berman’s Joe Rotter about the intricacies of investing in the pre-IPO space.
For many centuries, the issuance of stock into the public markets was the primary avenue for raising capital to fund future growth.
In fact, the oldest known, tradable share certificate was issued more than 400 years ago by the East India Company in the Netherlands. It is dated 9 September 1606, the same year that Willem Janszoon, captain of one of the company’s ships, became the first European to set foot on the Australian continent and map part of its coasts.
But in the last two decades, the number of public listings has fallen noticeably, while the average business also tends to stay private for longer.
In the United States, the median age of a company at the time of its initial public offering (IPO) is 11 years, while prior to 2000 it was eight years. In the late 1990s, the number of listed companies peaked at more than 8,000 in the US, while today it is almost half that at 4,642 listed vehicles.
There are a number of reasons for this development. A key one being a series of financial scandals in the early 2000s involving companies such as Enron Corporation, Tyco International and WorldCom.
These scandals resulted in new regulation being introduced in the form of the Sarbanes Oxley Act of 2002, which introduced more stringent recordkeeping requirements and stiffer penalties for breaking the rules.
The increased regulation came with a need for greater transparency and led to higher compliance costs for listed companies, making it less attractive to pursue a public listing.
Another reason can be found in the cost of capital. The steady decline of interest rates after the Global Financial Crisis on the back of lenient monetary policy added to the appeal of raising capital from private backers, since interest payments were more than manageable.
For investors, the tendency of companies to stay private for longer poses a problem, as more of their growth trajectory takes place outside of public markets. Of course, they can play in the private markets too, but there are often constraints on how much illiquidity they can have on their books.
In Australia, this is most certainly a concern, since superannuation funds are subject to the 30-day rule, which generally requires them to transfer a member’s balance to a competing fund within 30 days if the member requests the fund to do so.
In addition, the government’s decision to allow members access to part of their super balance under hardship rules during the COVID-19 pandemic further emphasised the need for liquidity in portfolios.
Yet, super funds need good returns too, therefore, there has been an increasing interest in finding solutions that make the best of both worlds. One way to tackle this problem is by investing in companies that are close to listing, the so-called pre-IPO space.
What used to be public market investing now really transpires in the private space. Investing in these companies while they are still private may provide attractive entry points into mature companies that are very far removed from the garage
By participating in this segment of the market, investors can potentially achieve higher returns than in listed markets, while not being too far removed from a liquidity event. These so-called “crossover equity” or “Pre-IPO” strategies aim to invest in companies that are well on their way to a listing. Investors in these strategies seek to generate private equity like returns with a quicker return of capital than most traditional private equity funds.
Joe Rotter, a Portfolio Manager and Chief Investment Officer at the Principal Strategies Group of Neuberger Berman, says this approach also means that investors are able to invest in companies that tend to have a lower risk profile than what is typically associated with private companies.
“What used to be public market investing now really transpires in the private space,” Rotter says in an interview with [i3] Insights. “Investing in these companies while they are still private may provide attractive entry points into mature companies that are very far removed from the garage, thereby positioning the investor to capitalize on the liquidity premium achieved when the company goes public. Conceptually we are trying to pick the horse when it is in the final stage of the race.
It also means that today’s IPOs tend to be larger in size than in the past and it is desirable to have the scale of a large asset manager to participate in these deals.
“Decades ago, the term unicorn was meant to be a billion-dollar IPO,” Rotter says. “You can see herds of unicorns now, and that’s more because you’ve seen these companies grow into it. These IPOs are coming out at $6 – 7 billion,” he says.
“Take, for example, Viking Cruises. It is a US$10.4 billion IPO. These are sizable IPOs and so you need partners that can take meaningful positions in these companies,” he says.
Entering Private Markets
During his career, Rotter has been mainly active in the listed space and, in fact, he initially was hesitant to start investing in the pre-IPO space as he was uncomfortable with the liquidity profile of these investments within the context of the liquid market vehicle he was managing. However, after reviewing data and discussing numerous deals sourced by his business partner Gabe Cahill, they decided to create a private equity vehicle to capture this attractive opportunity.
“We were invited to invest in a number of private rounds as a crossover investor,” he says. “We assessed the opportunity, but we had a liquid vehicle at the time and so I vetoed it. I did not feel comfortable with an illiquid asset in a liquid product.
“But I made a mistake, as these investments turned out wonderfully for that private round of investors. A few made a roughly 100+% returns in approximately 18 months,” he says.
Although Rotter and his team invest mainly in pre-IPO companies, the strategy is very different from a straightforward private market strategy since the aim is for all portfolio companies to eventually list on the stock market. The timeline to an IPO is approximately 12-24 months after the private investment, leading to a faster return of capital and relatively shallow j-curve when compared to other private market asset classes.
Asked how he deals with companies whose planned listing falls through and remain private, Rotter answers that there are options in the secondary market to sell these businesses.
If you don't see a path to it going public, it's just not ready for the public markets or would not be well-received for the public markets but it's still operating well, there are often strategic buyers for the asset, private equity or a secondary market in which to sell those shares
“If you don’t see a path to it going public, it’s just not ready for the public markets or would not be well-received for the public markets but it’s still operating well, there are often strategic buyers for the asset, private equity or a secondary market in which to sell those shares.
“You’re not going to have a 100 per cent hit rate [in listings], so for some you might have to find an alternative exit. In this environment, given the lack of distributions to investors from the VC community, there are interesting opportunities to sell and purchase secondary shares. There are times that we’ve purchased secondary shares from private sellers.”
The secondary market has broadened dramatically over the last few years. In fact, it is often a strategic recommendation from the bankers to complete a “crossover round” prior to an IPO. This round is designed to replace early investors in need of liquidity with crossover investors to remove the selling pressure after the IPO. It improves the probability of a successful IPO when the public side of the crossover investor is engaged and building positions at IPO and afterwards when compared to the post-IPO selling pressure created by early investors in need of liquidity.
IPO Reception
Typically, Rotter and his team invest in mature businesses that have experienced management teams and boards that include venture capital specialists and industry experts. In the crossover round they are not necessarily looking for partners who can improve business operations but rather one who can maximize the probability of success of their IPO and to help transition the ownership base from private to public holders.
Rotter and Cahill have vast experience in assessing how a listing will likely be received by the market, and they can help position a company in a way that is most attractive to public market investors. In fact, Neuberger Berman serves on the board of many of their portfolio companies to help facilitate this process.
“As companies prepare for their IPO., companies often debate revenue growth vs. profitability, appropriate levels of debt, public market research coverage and underwriter selection. Given their public market experience, these are just a few of the questions for which a crossover investor has specific expertise to help guide a company through its public listing process toward a successful outcome.
“We provide a consultant-like relationship and help solidify or reduce risk in the IPO process. We say to ourselves: ‘Where would this be valued in the public markets in a normal environment?’ We envision the ideal corporate position as a public company, we then work backwards to craft a strategy that helps position the company to best achieve that result as they approach their IPO.
We say to ourselves: ‘Where would this be valued in the public markets in a normal environment?’ We envision the ideal corporate position as a public company, we then work backwards to craft a strategy that helps position the company to best achieve that result as they approach their IPO
“In any investment, whether it is private equity, real estate, or public market investing, to be a good investor and calculate a good entry price, you need to have a very good understanding of your exit. The exit informs the entry,” he says. “We work backwards and adjust for risk to determine our investment price. Underwriting to an exit using the bottom end of a normalized historical range mitigates the impulse to chase the market. The key being a “normal environment.” This investment process keeps us disciplined. We made very few investments in 2021.”
Deal volume has started to grow following dramatic declines in activity after the frantic pace of 2021, Rotter says. “The bid/ask between buyers and seller has narrowed dramatically. Good businesses have had ample time to grow into their 2021 valuations, and as they prepare for an IPO, a reasonably priced round can help accelerate growth into and after the IPO while strategically releveling their cap table with crossover investors.”
In fact, valuations and terms are much more balanced, if not investor friendly, making for what could be an attractive vintage for the crossover equity asset class.
This article is sponsored by Neuberger Berman. As such, the sponsor may suggest topics for consideration, but the Investment Innovation Institute [i3] will have final control over the content.
__________
[i3] Insights is the official educational bulletin of the Investment Innovation Institute [i3]. It covers major trends and innovations in institutional investing, providing independent and thought-provoking content about pension funds, insurance companies and sovereign wealth funds across the globe.