A Strategic Look at the State of the Markets in Q1 2022
Insight by Larry Wieseneck
The Markets have changed pretty dramatically since June 2021 – the last time Larry Wieseneck, Co-President of Cowen and Company, Grant Miller, Head of Cowen Capital Markets and David Erickson, Senior Fellow at the Wharton Business School sat down to discuss current market conditions. Now, in February 2022, they discuss where they think the markets are now and how Cowen is advising companies to prepare for the near term.
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Transcript
Speaker 1:
Welcome to Cowen Insights, a space that brings leading thinkers together to share insights and ideas shaping the world around us. Join us as we converse with the top minds who are influencing our global sectors.
Larry Wieseneck:
Hi everyone. I’m Larry Wieseneck, co-president of Cowen and Company. And welcome to our first podcast of 2022. As always, I’m here with my good friend and former colleague David Erickson, senior fellow at the Wharton Business School. And today we are once again joined by my partner Grant Miller, Cowen’s head of capital markets.
The three of us last sat down to discuss the state of the capital markets in June 2021. And now in February 2022, we’re ready to pick up the discussion where we last left it off. So David, I turn it over to you. It’s been a while since we last sat down, I’m excited to kick off our discussion.
David Erickson:
Great. Thanks Larry. And welcome again, Grant. So look forward to having a robust conversation about, kind of dovetail with some of the topics we talked about last summer. So obviously the markets have changed pretty dramatically since we all got together last summer. Where do you think we are now, and how are you advising companies to prepare for the near term? Larry, why don’t you start.
Larry Wieseneck:
For the first time in many, many years, we’re dealing with a backdrop of really global, sometimes we think, from the US, we start with the Fed and work backward. But if you think on a global basis, central banks are beginning to take some of the liquidity out of the market. And so we’re in the beginning of a tightening cycle. And for many market participants, this is something that they’ve either never experienced or if they did, it was when they were much earlier in their careers. We’ve had roughly a decade of almost uninterrupted loose and loosening financial conditions. And I think that that is the the number one item that’s out there in the backdrop of the market.
Now, why are they doing that? Well, they’re doing it because of after so many years of providing liquidity, it does feel as if the conditions warrant it. Secondly, while we hadn’t had fiscal loosening for a long time, when the pandemic kicked in, the US and other governments, did provide significant benefits to offset the impact. And now we’re seeing the other side of that. We’re seeing certainly at least, short term inflation pickup, expectations for future inflation continue to be more elevated than where we’ve lived in for the last 15 years. And that’s creating an environment where the central banks are moving, what I’ll call toward neutral. Because even with the moves that they’re contemplating, we’re not moving to a tight monetary environment, but we’re moving from very loose, to less loose. And the market’s been pricing that in.
And what we’ve seen is, everything from the higher growth areas that are the most impacted, if you have higher interest rates, and if you have inflation at higher levels, they’ve traded off dramatically, but we’ve also seen volatility across really all areas of the equity market. We’ve seen it obviously in rates and we’re starting to see it in credit. So I think that we are two months plus into that recalibration by the markets. And I don’t think we’re out of the woods yet, but I do think a significant portion of what’s known now ,there’s no knowns, no unknowns. the known known here is that we’re moving to tightening and it’s become priced in. And so, Grant, may have to take it over to you to talk about that.
Grant Miller:
So I think that just how that relates to the activity in the capital markets is significant. Maybe I’ll hold the credit side for a moment and just talk a little bit about the equity markets. Where we are today, I think it’s important actually to take a little bit of a step back. The S&P is still trading at 20 times ’22 earnings. That’s not a bad place from evaluation perspective. So what we’re seeing in the equity markets is uneven. And we can certainly talk more about how that relates to capital markets particularly in growth industries, because I think that’s important. Also what’s happened in these situations when we’ve seen rates hike and capital is really available, is what we saw last year, really for the last 18 months, is retail coming back to the equity markets, helping deals get done in a very material way, that has really gone away, almost completely. It snaps off reasonably quickly.
And so where are we today? We’re in a situation where the capital markets are quiet. But we’ve seen this before, and we know that things come back and there just needs to be a little bit of a resetting of folks both getting used to their new valuations. And as we going to talk about a little bit later, investors still didn’t make money. In the near term when we have this resettlement of kind of where deals are coming and where indices are, it does take a little bit of time.
What we’re seeing as a general trend is that the deals that are coming have the following characteristic, which is you have to be supported by those who already have been supporting you, existing investors, public and private, are supporting deals. And that’s really where we are. And until we see new investors coming back into deals and making money, I think that’s going to persist at least for the short term. But I really believe in efficient markets, and so this too will change as the deals get priced and companies get priced appropriately, and will be on the way back up.
So how does this… I think Dave asked you about, how does it change what we tell companies or what we’re talking?
I’ll try to say this in a way that gives them a football analogy since we’re going to be coming up here the end a football season, which is, and maybe a little bit of a dig to Larry’s team, the Jets, and supporting my team, the Patriots, which is, I think that in these situations when things are uncertain, management really matters in a very material way.
And so today I think that when you look at situations, you need to make sure that you have the wherewithal either in traditional financings or in financings that you haven’t considered before to make sure that you’re planning for the future, including your existing. And these are really comments for companies that either have maturities that are coming up or spending money. And how it relates to Jets versus Patriots is that I think over a long period of time, it’s a great microcosm because every NFL team has the same opportunities. Some institutions and some management teams parentally figure out a way to be winners and others are less fortunate sometimes. So that may have aggravated a lot of listeners who also don’t like the Patriots. I think the two of you are among them, but at least it’s an analogy of-
David Erickson:
Leave it to a Patriots fan to bring up the Patriots on the week of Superbowl even though they’re not in the Superbowl.
Larry Wieseneck:
I’m a little wounded. I’m a little wounded by that, because I understand the analogy and we’ll just roll on to the next question.
Grant Miller:
Very good.
David Erickson:
So let’s talk about the IPO market. Obviously it was a huge market or a record market last year for IPOs as well as SPAC mergers. And something on the order of 80% of those companies that went public last year are now trading below the level they went public at. So for those newly public companies, what’s the nature of your discussions in this environment?
Grant Miller:
Yeah. So look it’s… And if we re-listen to what we did back in June, I think that we started to talk about this, because we saw some unevenness even back then. And so I’ll just reflect on this, that very overwhelming 80% are below deal price. That is true both for IPOs as well as back mergers. However, when you think particularly in the SPAC market where evaluations are struck six months before closings, and you have an equity market that is declining, I think that that can be understandable in terms of the context. It’s similar for IPOs and just in that type of environment.
What’s happening to those? And if you look back, the valuations also were extended. I was just looking at some of these statistics. The median post money value for IPOs last year was about a billion two. That’s up from 800 million in 2020. And so last year was also a year, to look at it historically, as a high valuation year. So things happened.
So now it’s reset, and the question is, is a reset something that is sustainable to go forward? So again, I think that where companies are right now particularly those that have gone recently public, is they’re trying to get the attention of enough investors to care and to recare as they look at opportunities going forward.
From a capital markets perspective, today may not be follow-on offerings that are the most typical next transaction to do for folks. And so that enters into the equation of, are there others? Are there convertibles if there’s a capital need? And what are you doing in this interim period to be able to support your existing investors, your research analysts who are out there to keep the news flow coming and stay active and not hide during this period of time? I think that is really what needs to happen until we see some of that normalization come back.
David Erickson:
Larry, how about you?
Larry Wieseneck:
Well, listen, I think there’re lessons learned from other periods where we’ve come off of high valuations. I certainly don’t believe that we are, on many other facets, analogous to the period post the dot com bubble bursting, but I do think on valuation, that is an area where we can make comparisons. The companies that came public during that period at let’s say elevated values, at least certainly six months later looked elevated after the market traded off.
And the lessons then, similar lessons that we would’ve seen in April of let’s say 2020 when the pandemic kicked in, is the first thing companies need to do is make sure that they are running their businesses in a way where they are assuring that they have the capital, the cash on hand, to manage their businesses. In some businesses that means slowing down their spend. In others that means raising capital, as Grant just said, in different ways than they might have anticipated so that they can continue to build out against their strategy.
But you always have to look at, do you have to change your strategy based on the different market environment? And I think using Grant’s example of the Patriots, better management… And, Grant, I’ll give you that one. But better management recognize that when the rules are changed around you, you have to change. And the markets put limitations on companies. We’ve gone from a market that had very little limitations before to significant limitations now. So I think that’s really, when you talk about the nature of our discussions, a lot of it is what do we do to make sure that we are continuing to execute on our plan? Do I change the plan or do I change the way I finance? And that’s an enormous amount of the work. By the way, it’s not just with public companies, it’s also with private companies where their opportunities have changed as well.
David Erickson:
Grant, you talked a little bit about convertibles, a little bit. So let’s go beyond just convertibles and talk about some of the implications of the rising rates in not only the convertible market but also the broader debt markets.
Grant Miller:
Sure. And so I think that certainly both hold in terms of what’s happening I the overall sentiment out there. So I think that it’s self reasonably early in this as rates have just began to climb. And the question is, how far will they necessarily go?
I guess my view is, a couple things. Again, maybe looking historically, we’re still in a historical low rate environment. So this is not like we’re back in the eighties when you had real high rates. And so we’re back maybe where we were at the end of ’19. So this is not anything that that is, I would say, dramatic at this point.
And then you look at things like sponsors, and Larry will have a broader perspective on this, but valuations are also now coming back in. So those two combined actually from a new issue perspective on, particularly with sponsors, actually can make some sense. And if you think about the rates going up and what really what’s happening in deals as the private credit markets have grown so substantially, they’re virtually the same level where the leverage loan market is in terms of the overall size, and four to five times where it was just 10 years ago. So it’s really changed the dynamic.
And what’s happened in the last couple years is, yes, interest rates are higher, but the competition for deals is also much more significant. So what we’re seeing in our business is that as these private credit funds compete for these transactions, we’re actually seeing an overall lowering or tightening of their spread with regard to what’s happening. And so some of this early stage of rate heights, I actually think has been mitigated with regard to the competition for those opportunities. So far I’m not anticipating a big shift unless rates really go crazy, but we’re still at the beginning of things that might be.
David Erickson:
So, Larry, how about from the sponsor perspective, to what degree are you seeing expectations of rate rises impacting sponsor deal flow?
Larry Wieseneck:
David, I’ve tried in our podcast to focus on those areas where we spend a lot of time. So I will direct this much more to the broad middle market sponsors where we spend our time versus say the mega private equity funds that would be doing much larger deals. And by the way, I actually think the middle market sponsors are in this case, in this type of an environment, potentially relatively benefited versus larger folks. And the reason for that is in the middle mid-market, what Grant was just talking about, the private credit investors direct lenders, that is the source of funding on the debt side for a middle market deal. But they’re not relying on a high yield market at all. In fact, the vast majority of middle market transactions are completely financed either from sponsor equity or from direct lenders or the club market, so to speak.
And why is that group relatively benefited? Well, it’s because it’s labor based funding. So in a world where rates are rising, the investor in that debt is not penalized from rising rates, or we’ll call being hurt by deration. So we are seeing more money on a relative basis going into those direct lenders, because if you wanted to have a credit exposure, where would you rather have it? In a floating rate instrument or in a fixed rate instrument?
And so what we’re finding is the market is really deep, which means sponsors today versus say six months ago are finding that they’re a better bid today than they were before. They still can have really good debt financing to back their deals, their long significant capital they’ve raised. And they’ve been waiting for a time where with the public market backing up a bit, they maybe can get a deal they’ve been targeting and they thought it got rich at whatever, 14 times EBITDA, and maybe now they can have an entry point at 12 times, and they can still get the same debt financing. So therefore it’s a better return profile for their investors.
So we think that as we look at ’22, it’s going to be a very good year for sponsor back transactions. And in particular, if I were to say, who gets implicated by that? It’s I think the family-owned businesses that are looking for a partner, where they might sell their business either majority or minority, and then have a sponsor helping them buy other businesses, grow their business, as well as some of the lower middle market sponsor deals that were maybe done three, four years ago. They made improvements in the business, now that company is a $50 million EBITDA company and they’re going to sell to most likely a larger sponsor. So we’re seeing all of that.
And we’re also seeing, even with the beginning of rates increasing, we’re seeing people do recaps. So we’re definitely seeing in the middle market, a lot of… Well, maybe now is not the right time to sell, but what I’ll do is with the additional cash flow, I’ll restrike my debt, do a recap, take some more equity out. And so it’s pretty vibrant in the middle market sponsor world right now.
Grant Miller:
And I’ll just add a couple other things just in the conversation where our private capital solutions group really does everything X ECM, including all this work in the private credit world. And so what we’re seeing is really those funds being flexible. We talk a lot about sponsors, but let’s take a step a little bit broader. These funds were also looking at hybrid debt securities preferred private convertibles. It’s really a new world out there with regard to solutions for companies to be able to address their needs in a way that’s a little bit changed.
And the other piece, and maybe as I was thinking about this, you guys were chatting about, historically, and we all remember some of the anxiety. And I certainly heard this from some clients around, is this like before the financial crisis when things were so loose? I actually don’t think so because there’s a lot more equity going into deals, to start. And frankly, in the last few years, there’s been a lot of issuance and it’s been a lot of covenant of light. So I don’t think that we’re going to be in a situation where we’re necessarily going to have in the near term, any credit issues. And so actually I think the market is reasonably healthy from those perspectives.
David Erickson:
Great. Grant, we talked a little bit about how the IPO market and the SPAC merger market has changed pretty significantly. And as well as with valuations coming off broadly in many of the emerging growth sectors that were very active last year, I assume like we’ve seen in previous periods where we go through this kind of correction phrase or resetting phase, that issuance is going to shift to more defensive sectors like traditional energy, industrials, consumer staples. To what degree are you seeing that today and expect that in the near term? And are there any other changes that are taking place now, or that you expect going forward?
Grant Miller:
So it’s really an interesting question. I think the short answer is that, I think it’s a little early to see those changes really emerge because we’re just at a lull right now as this resetting as you say, is kind of we’re in a little bit of the middle of, and I think that’s very, very natural.
It is also true that if we just look at the last few years in terms of IPOs, that about 75% over the last few years the IPOs have been in disruptive industries, tech and healthcare. Specifically 75% of those two industries. If we go back to just the post-financial crisis, those two industries accounted for less than 40% of the overall issuance. And between those two time points, you see kind of a little bit of the connecting the dots, if you will.
And so do I expect that there’s going to be some reversion and having more balance to the markets and what investors are looking for? Absolutely. And I think there’s going to be value in companies that have both growth because people still want growth in their portfolios, but also more consistent performance with regard to understanding and being the next inflection point.
So I’m expecting it. I wouldn’t say that we have necessarily seen it. Although if we look at our backlog, I do see that the backlog has been in more, let’s say traditional consumer, for example, where we’re seeing a lot more things come up. But this is also a trend line that’s stretching over months, not just maybe just the last couple weeks and months as the market has started to slow down a bit into those areas.
And it does point out, and I think this is maybe what I referenced at the beginning, and come back to it, which is the market’s been uneven in terms of what’s working and what’s not working. And a lot of it is hitting the deal market. So if I just look at the last month, if you just look at January for example, where the indexes were, I think is telling. So part of our important business is financing biotech companies. The small cap biotech index XBi in January is down 16%, 17%, the highest risk part of that market basically. But then if you go and you look at other areas. So last month NASDAQ, which I consider kind of the next large threshold, was down nine, S&P is five, Dow Jones, three. And so this unevenness is there. And we’re starting to see some of that earlier stage higher multiple sectors, biotech and also tech, start to really advance and maybe the rest is catching up with a little bit, but it is, it’s not all one-size-fits-all. It really has been depending on what’s going on in individual sectors.
Larry Wieseneck:
I think Grant brings up some really interesting points. And I think the one that is maybe the hardest for folks who aren’t the deal calendar and aren’t following the sub indices, is to recognize that the market’s always overshoot. So even implicit in your question, David, we talk about what’s happened over the last year, there are companies that overshot on the high end, meaning that their values may be, if you looked at the beginning of 2020, we would’ve thought they were worth $400 million. They came public at 2 billion, because the market had completely revalued growth. And now they’re down 50% post IPO or post back merger and they’re a billion dollar companies. If you had told their private investors at the beginning of ’20, that it was a $500 million company and it’s going to trade at a billion and two post IPO, they would’ve been thrilled. But it doesn’t feel great because it went to 2 billion and came back down to a billion, a billion two.
And I think we’re starting to see that now on the other side, which is, for the first time I’m starting to feel… And I say first time, meaning over the last month, that the selloff in some of the disruptive areas may have taken them down relative to intrinsic value. They start to look as if they’re more valuable than some of the private companies that recently raised money and basically are sitting at evaluation that maybe that’s what’s overvalued, right? Meaning the last raise the private company made was predicated on a public market that looks different.
How that works through in terms of deal issuance is, I think that slows down the disruptive names coming to the IPO market. They raised money nine months ago in a private round at an elevated level. Already public companies, to Grant’s point, figured out how to either husband cash or raise capital different ways. They become bigger winners. They’ve got more capital, they could then do acquisitions. One of thing we’re expecting to see is mergers among some of these companies in some of the growth areas, because they can de-risk by having more shots on goal. We expect to see that. We’ve seen that in prior periods, certainly in biotech, we expect to see that in of course in tech.
But then I also think when we talk about industrials, consumer, even some of the things in energy, the businesses that might come public now, where you issuance from now, they may be in spaces that are old spaces, but guess what? They’re tech enabled. Their margins are better than they would’ve been five years ago. They are using technologies to change their industries. And they’re almost somewhere between what we’ll call the disruptive spaces and the historical. In some respect, they’re disruptors within old school industries. And so I think that’s going to be a lot of what we see in ’22, is that churning. And I do think that it’s going to make for a really interesting time. And I do think the public to public M&A opportunities among companies that recently went public is going to surprise people to the upside.
Grant Miller:
I do want to maybe add one last thing, and I know you probably want to go on to the next question. If we look at these things, their is trends, and I think that the market self-correction mechanism is alive and well. I’ve looked at pre-revenue SPAC mergers. A set of higher growth, higher expectations situations that… And valuations through last year went up significantly. So Q1, the median valuations of those pre-revenue was closing at around eight to 900 million. It peaked at about 1.3, 1.4 in the third quarter. So again, there’s delay in terms of when they were announced and closed. And now they’re back to where they started. And so I think that it is just an indicator that there is this self-correction that we’ll get back to valuations that make sense. But we’re not… And it’ll be a slow down certainly in activity, but I’m very optimistic that what we’re seeing across our growth industries is so disruptive that there might be a pause, but this, I would characterize it as a pause.
David Erickson:
So how do you see those private companies in those disruptive industries, financing themselves in the near term, given kind of this shift?
Larry Wieseneck:
And Grant, let me just take a mega macro point there. And I’d love to have you talk about the actual funding. But what’s interesting to me is we see this in lots of markets. We’re talking about private now, but we could be talking about the convertible market, the IPO market. When things do well for a long time, accidental tourists show up. And what we were seeing for the last three year in late stage private for example, were people that were not skilled in private ownership, nor were they set up to have long term hold periods. So for example, a hedge fund that has basically daily or monthly or quarterly liquidity owning significant portions of private companies. Those are, again, I would use that the term accidental tourists for that. That’s not their core area. Those folks have run away. They’re not going to be the predominant investor in late stage privates.
So what’s happened is, we’re rolling back to the experts in an area are the ones who’ll be pricing deals. And so we’ve taken some of the fraud away, public markets straight off, therefore the private market ends up trading off. But what’s interesting is there is so much capital still available within dedicated private funds that I think they’ll still be a very interesting market. What’s interesting, Grant, is, are the deals changing? How does that impact the deal? Taking some investors away, what does it mean for investors and for the companies?
Grant Miller:
It does. And so I was actually to make similar point, that privates are meant for long term capital vehicles. I do think that some of what we ran into and why we’re having a little bit of difficulty is that many funds got away from that. And so they had a 10% hold for privates and the rest of their portfolio went down by half, now they have a 20%, and now they have to reset. And so I think those are real issues and it does take some time to unwind that dynamic. So I certainly see and I think it’s a really good point.
I also think, in our business, a couple years ago we had a number of private situations looking for equity. And we really went over to our SPAC business and there was a really good SPAC mergers based on the way the market was. We’re seeing that a little bit in reverse now where the SPAC may not be quite as robust as it was the last time we all chatted. And so we’re seeing really good opportunities go from that market back to the traditional private equity placement market.
And so to us, I don’t think it makes a difference for talent, we’ll find you the right type of capital that makes sense at the time. We see right now the largest interest and backlog in our private equity placement business, then I have seen in my 13 years of talent. And I think that is very much on par. And I do think that we have to be careful because there is a pause, but again, good value. Long term capital will find them. And I’m very optimistic about that part of the market.
David Erickson:
And I want to dovetail with that point, Grant, for a second, because I guess this is… We’re running out of time, so I wanted to kind of… You’ve talked a little bit about some of the types, how the market is reshaped for those private companies. And Larry, you talked a little bit about the expectation you have for some of those recent public companies potentially doing some acquisitions or strategic transactions. Talk a little bit more, Larry, if you would, about what you’re seeing in this current environment in terms of strategic dialogue.
Larry Wieseneck:
I think one of the elements that we really started seeing picking up two, three years ago, and maybe it was part and parcel of what Grant just highlighted, which is by having a very robust private capital markets effort that crosses equity debt, we’re seeing deals come together that we hadn’t envisioned five years earlier. An example of that would be in the private market, the equivalent of a syndicated commitment for an M&A deal. So if you think about, if a large company is doing an M&A deal, they work with their lead banks, they line up a $10 billion facility to fund the deal. What we’ve now seen, and we’ve done a bunch of, is working with a company, it could be private to private. We’ve done some which are reverse mergers, where the private company’s merging with a public company. But to get that done, they need new capital. And so what we would do in those situations, is have a private debt dialogue with club lenders regarding their ability to fund that. At the same time, lining up, if it’s equity, private equity. If it’s a public company, a pipe in order to fund it. And then when we announce the deal, the entire capital structure has been funded, all done, obviously under NDA confidentiality, et cetera.
We think, again, that’s just one example, that’s the kind of market we’re in. Grant can talk to me for a second about CMPOs and what we think is going to happen there. But it’s the same thing where people don’t want to take the market risk when they announce an important transaction, so they basically end up having to do pre-marketing under confidentiality and NDA. Grant, take it to you [crosstalk 00:33:35].
Grant Miller:
Yeah, I think that’s exactly right. So we’re seeing the tact, alcohol mode tactics. Remember, what we’re saying is be careful. So that’s, test the water for IPOs, that’s confidentially marketed transactions. For public issuers, that’s looking to other sources like at the market offerings, which are really big business for us. And actually you see some big blocks of interest come through you know there are buyers out there, and you get information, and also be able to sell. And then you look at other products as well. And again, I’ll go to convertibles or structured equity, where you can do things in what I would say, in more tactical way for the environment that we’re in today.
David Erickson:
Great. Guys, I know we’ve run out of time. I know that field goal kicker’s coming on for that last play of the game. So we got the Superbowl coming up, so enjoy. Again, Grant and Larry, thanks so much for the time. It was a robust discussion and look forward to next time.
Grant Miller:
Me too. But look, next time, unless the lockout for assists, I’ll try to make an analogy of the Red Sox, which is not going to be quite as strong for me as, but I’ll do my best.
David Erickson:
Great.
Larry Wieseneck:
And on behalf of Cowen and our listeners, David, thanks again for being such a wonderful host, and look forward to speaking again soon.
Speaker 1:
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