A Strategic Look at the State of the Markets in Q2 2022

In this episode, Cowen & Company Co-President Larry Wieseneck once again speaks with David Erickson, Senior Fellow at Wharton Business School, and Grant Miller, Head of Cowen’s Capital Markets Group.

Back in their February podcast, these three capital markets experts started with the question, “Where do you think we are now and how are you advising companies to prepare for the near term?” In this episode, we asked with the same question now in late June 2022.

While the public markets have been choppy, we are starting to see companies turn to less dilutive financings and the private markets.

Press play to listen to the episode.

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:

I’m Larry Wieseneck, Co-President of Cowen Inc. Company, and welcome to our podcast. We are recording this as we kick off July 4th weekend, and we hope you’re finding some time to relax because certainly we all need a little R and R these days. As always, I’m here with my good friend and former colleague David Erickson, senior fellow at the Wharton business school. And today I’m happy to say that we are also 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 February this year. And now nearly five months later, we’re ready to pick up the discussion with quite a lot to talk about. So David, once again, let me turn it over to you.

David Erickson:

Thanks, Larry. And good to talk with you again, Grant. Let’s start with, where do you think we are now? Because we talked a little bit about this in February. Where do you think we are now and how are you advising companies to prepare for the near term?

Grant Miller:

It’s been quite a last couple quarters in the markets and deal activity and actually I went back and listened to the podcast we did back in February. I might be the only one that listened to it twice, but I did to see how we did last time in terms of what the last five months it’s all been about. And I think we had the right directional view is weren’t sure we’re at the bottom and we certainly were not. I do feel a little bit better where we are. Last time we talked about just where the market is trading and back in February, the S&P was trading at 20 times forward or 12 month forward earnings, which is still high of a historical basis. Today, we’re at 16 times. That is a little bit below the 10 year average for that metric.

I think that is way more in line where people can start to understand that valuations are coming into an area that can make some sense. It’s certainly true that the economy may suffer as interest rates need to go higher, but now we’re at least in an area where you can see broad market valuations making a little more sense. So I think that from that perspective, I actually think that we’re in a better spot, notwithstanding that when you look at some of the sectors that Cowen and Cowen spent a lot of time with, you look at the biotech IPOs since the beginning of 19, fully 40% of those companies across the street have a negative enterprise value. And so again, there are two ways to look at it that has been tough to take for those companies and investors that have not done well, but we are certainly seeing what you could imagine are valuations reset to a level where people can really come in and start looking again.

And so in terms of the advice, make sure that you don’t rely on the capital markets right now because it’s very hard to rely on getting good deals done. One of the pieces that we’ve really started to talk to folks about, particularly in small cap and midcap, which are where most of the capital markets deals are including for Cowen, is that relationships matter. And what I mean by that is that when you get back to fundamentals and investors trying to find interesting stories to invest in, particularly in the context of the capital markets transaction, they’re investing in story, they’re investing in the future and they’re investing in people. I think, we are now really starting to come out of is the pandemic is the opportunity to actually build relationships between investors and senior management teams.

And at Cowen, that’s our job to put those two worlds together. And I think really that does make a big difference. And so in terms of what we’re doing for non-deal road shows and conferences, we are doing as much as we can to put people together so they could rebuild some of those relationships that are either new for the IPOs that never met company and that investors live or rebuilding it. So I do think that’s a lot of what we’re focused on in terms of where we go with the current environment.

Larry Wieseneck:

Yeah, I understand. I think Grant brings up a really good point and we can look at a few time periods in the not so distant past where those that took the advice that Grant is highlighting really benefited. We can just go back to March and April of 2020, the companies that got close to their providers of capital, whether that be in their debt stack, making sure that they were keep talking to their top 10, 20 lenders, whether it was public companies, making sure that they were staying close to their shareholders and also those that had been kicking the tires and then for private companies making sure that they were in dialogue with their existing owners, they all were served really well when the market got better because they had invested in the relationship and they had been transparent and kept folks up.

If you look even further back, go back to the global financial crisis, same thing. I can remember conversations with the largest investment grade kind of companies talking about for the first time ever them doing debt holder relations. We often talk about shareholder relations. They needed to make sure that in those difficult times, their bond holders understood what was going on at the company, the steps they were taking and then when the market got better, they were the ones that benefit the most of the tightest spread. So this is really important because it’s not about executing today, it’s about being prepared to execute tomorrow and those who prepare are the ones who ultimately are in best position.

David Erickson:

So I know the IPO market’s been quite limited for the last few months, last several months actually now. What are the characteristics of those companies that have still gone public? And for those companies that we’re hoping to go public in 2022, but they may not fit that profile, what are you advising them that they should be doing now?

Grant Miller:

Well, yeah, so the IPO market is just really dormant. There have been a kind of a scattering of IPOs, but really, almost hard to make a trend line out of such a few number of companies. Even some larger companies that have just have a hard time getting out to begin with. I think that what folks want is stability and predictability, but even with some of the slower growing companies that there are people that just want to put their hands in their pocket and forget about it.

And so the companies that have gone have basically had a path prior to starting their process, where they knew the IPO would be placed. So that means existing shareholders making the decision with their boards, that being public is a benefit to that company versus staying private and essentially at Cowen and across the street our advice has been, if you’re going to go out, you need to have the deal covered, meaning that we know from their test of water meetings and existings that the deal is essentially done because it’s been quite challenging finding new investors to step into those situations, which basically means the IPO market really is for the most part shop for the time being.

I would say however, and I think interestingly, the spec market, the spec merger market is still reasonably active. We have probably more live spec merger conversations going on right now than traditional IPOs. And so that might sound odd given that in the news, you turn on the news and you hear everything bad about the spec market, not true. The spec listing market, they got so much attention last year, that’s different. I’m talking about existing specs merger with the operating companies.

David Erickson:

Relating to that, how is the pipe market related to the spec merger market?

Grant Miller:

Yeah, no, exactly where I was going to go, which is, has some of the similar dynamics. What we’re seeing is because what specs are basically when you do the merger is, you know the answer, meaning what the deal’s going to look like because the pipe you’re putting together that will be announced concurrently with the merger before going through the entire SEC process. So it’s basically getting the answer first and then all the disclosure second, versus an IPO process where you spend all the time going through the SEC first, and then at the end of the day, on a pricing day, the underwriters will tell you what you’re going to live with.

And so in that context, knowing who’s going to come to the table and how that’s going to look for a spec merger is attractive to a number of companies, so that can be strategic investors, we’ve seen a lot of that, existing investors, specs that have a forward purchase agreement so that their money is coming from the spec themselves. And so while the activity level is still much lower than it was, it is on a relative basis on a more active than maybe even the traditional IPO market for some of those reasons.

David Erickson:

Wow. Okay. So last time we talked about the implications of the rising rates and the dead markets, and obviously we’ve seen the Fed pretty active in recent months. What types of deals are you seeing in the middle market sponsor back market today, Larry?

Larry Wieseneck:

When we spoke in February, I probably believed that the tenure, let’s use tenure as kind of the point of the curve that really impacts deal market the most, it’s not the short end. I probably thought that we’d see rates even higher than we are today. Roughly we call it a hundred base point move in the tenure while that seems like a big move from where we’d been just three, six months ago in the scheme of the last 20 years, we’re still looking at what is in the two standard deviations away from where historically the tenures been. So it is still very much a borrower’s market, spreads have not really backed up that much in the middle market, mostly because what we’re dealing with there is not the fixed rate market, but rather floating rate lending market and mostly direct lenders.

And those direct lenders are flush with cash. One of the things that’s happened is as the public equity markets have obviously been repriced as the high growth names in the venture market have clearly seen the repricing, money has flown even more on a relative basis to the direct lenders. So therefore the financing for these middle market deals is still there. What’s happened is the sellers have had to reconsider, do they want to do a transaction, sell their business today when there’s uncertainty around what their EBITDA will be? And again, this, for the majority of private market MNA, they’re being traded off of EBITDA free cash flow, they’re being squeezed there. Certainly there’s fear of squeeze, right? So input cost going up, certainly labor cost going up. How much of that can I pass on to my purchaser?

So what we’re seeing right now is the negotiations on deals is now more balanced. It was a seller’s market in 2020 and 21. I think there’s a balance now between a buyer and a seller’s market. So what does that mean? Companies that believe they can really benefit by having smart PE investors alongside them for the next phase of their growth, they’ll do deals cause they’re not looking to get the highest price. They’re not looking to necessarily top tick. The deals that are falling away for those where it was opportunistic. You know what, I see where the value is, love that price, not sure it’s going to stay there. I’ll sell, those deals aren’t getting done right now, but in terms of where it’s a balance and it’s a good deal for buyer, good deal for seller, we’re seeing the MNA market in that middle market continue to be quite strong. My estimate for the year is it’s probably down 10, 20% overall from last year, but last year was a record year.

Grant Miller:

I think the syndicated markets being dead, it’s amazing the process they were running going to the private lending community, how active and aggressive they still are. And so it really hasn’t moved nearly as much as I would have anticipated because the competition among those lenders.

David Erickson:

So, Larry, just so I’m clear. So you said down 10%, what does that mean, regarding the MNA market?

Larry Wieseneck:

That I think middle market sponsor back MNA, well in the year, somewhere down 10 or 15%, but it’s not because there’s not buyers that want to put money into work or lenders. It’s going to be that the sellers who were somewhat opportunistic have fallen away. And one of the things that also for the US market, we have to be cognizant of, 20 and 21 both saw a lot of deals in the second half driven by tax fears. So if I don’t sell in 21, I worry there’ll be a tax deal that will basically increase capital gains, so I don’t want to sell in 22. That move forward deals first 21 to 20, because the election then 22, 21, will they come up with a tax deal? That spec was gone. There will be no changes that are going to impact CAPA gain, so that element of the market that was sellers trying to beat an increase in CAPA gains tax won’t exist again until maybe 24. So we’ve got some time there, that’s gone that piece of it.

David Erickson:

So for most companies with equity prices off, in many cases significantly, you still have companies that would like to do financing or need to do financing, but maybe unwilling to want to worry about the potential dilution and unwilling to use equity. What type of financings are companies doing in this category?

Larry Wieseneck:

Let me let Grant talk about the financing side. I just want to talk about one thing that we haven’t covered yet that is built in here. Little bit hits your IPO question, also hits this. I think there are a lot of companies who believe in a more volatile financing market that they’re too small on their own to continue to live in that environment, if this goes on for 12 or 24 months. So one area where there is some MNA opportunity, and what we’re seeing is companies that they believe they were of scale maybe a year ago are less of scale today.

So there’s MNA activity of two companies in the same sector, maybe complimentary would’ve gone alone, coming together now, solving their financing problem. Cause there’s a bigger firm, more stability, more cash flow, more revenues, whatever. They’re both a better financing entity, but importantly, they can withstand this volatile time. So that I think is the first thing, I’ll start strategic. That’s going to be a big part of what I think is the MNA of the next 18 months. Now let’s talk to what if they don’t have an MNA alternative one of the financing choices?

Grant Miller:

Yeah. So look, I think that I would’ve predicted and would’ve been wrong that the first market to really return would be the convertible market. And the rationale for that is that volatility actually increases the value, we’ve seen a lot of volatility, and there’s a backstop on the credit of those companies. We just simply haven’t seen that yet and so even with the stocks bring down so much, if we’re looking at 30% premium, let’s say on a convertible, that’s still way below where they were likely just two quarters ago. And so last year at this time, the market had priced 95 convertibles. So far this year they’ve just been 16 and that ratio is very similar to what we’re seeing in the follow on market. Now that is still above the IPO comparison. But nevertheless, we haven’t seen that really start to come to phrase.

So, what are folks doing? They’re being careful with respect to making sure their deal gets done in a kind of a brick by brick way, rather than throwing the doors open and see who comes. And so that means a lot of confidentially marketed transactions are happening to make sure that you know where the demand is. But if folks don’t like their price, it’s a hard mark to try to convince folks to come in and pay a good price because investors still aren’t making money on these deals. Even though that they’re down a lot, year to date follow ons, for example, investors have lost money. They’re down seven to 8% year to date. Typically, that’s usually a three to 5% increase and so if you’re an active investor, you want to use that deal calendar to helping you make money so far this year, that hasn’t played out.

And so it is a challenging environment. So what companies are instead looking at or trying to figure out a way to how do you finance your business plan with ways that are less dilutive, not non-dilutive in some cases and so what we’re seeing is our at the market programs, which allow companies to sell small amounts of equity over time increase pretty dramatically. And so those are available that you don’t want to market a hundred, $200 million deal, but you really feel like you need to raise 15 or 20 million dollars this quarter to offset burn, that’s been way more popular. And those programs are available for companies that have, are S3 filers or in public for more than a year. Many of the companies we’re seeing, particularly companies that have de-speced have been looking at a new product called Equity Lines of Credit, or ELOCs, to essentially as a predecessor, to be able to be an ATM filer.

They’re more expensive, but we’ve seen 50 of those filings so far this year, and that is a huge increase. And so it’s really more of a how can I backstop the opportunity to make sure that we’re going to be well financed? I’ll take a second as an aside, when you look at biotech, which is just an important sector for Cowen, and one of the most active in the public markets, we are seeing an incredible increase in activity in non-dilutive ways to finance. Those are debt deals. Those are term debt deals where we’re getting excellent terms. Particularly when you look at the cost of capital and stocks are down, it looks attractive. And we’re looking at royalty sales and synthetic royalty sales, that for many of these companies are an outstanding way to be able to raise capital.

So you’re essentially, it’s a product level transaction versus an equity transaction. And in those areas, in what we call our private capital solutions group, which is really everything outside of ECM, we have had the busiest two quarters that we’ve ever had. In fact, this first half of the year is we did more deals than all of last year. And so that shift has absolutely happened to find ways. Now that’s not applicable to every company, but that’s why we’re looking for those solutions that are maybe either less dilutive or in some cases non-dilutive to equity.

David Erickson:

Well, it’s great to hear that there’s some interesting things going on, despite the fact that the turbulence we’ve seen in the overall markets. So we’ve touched on MNA, in a couple of different avenues thus far. We talked a little bit in the middle market space. We talked a little bit about a couple other areas. While MNA activity overall has slowed down, what areas are you seeing the most active conversations today? And what do you think are the types of transactions are going to get done?

Larry Wieseneck:

And David, I’m going to presume here for a second, we’re really talking about public market MNA, I think we’ve addressed the private PE based MNA activity before. So I think, what’s really happened and Grant hit this implicitly when he talked about some of the deals that were poised to do and what folks are thinking about, unfortunately, businesses are run just like everything else in our endeavors, by humans that have recency effect in the way they look at things. So if you think about when we spoke in February, other than maybe in certain parts of life sciences, where the trade off had really started in the second quarter of last year, in the first quarter, most of our clients were shell shocked. The selloff kind of began in November, December, they thought it was going to be temporal.

And it became clear, now this is actually a longer term repricing due to inflationary fears, interest rate increasing, et cetera. That impacts everything from how do I finance to do I have to change my growth plans? Do I lay people off? To ultimately the most strategic decisions, do I change what I think my mix of businesses should be? And I think that we’re now, here we are halfway through this year, at the point where companies are recognized we’re in a new regime and this new regime may be longer than they expect. We may be in a world of elevated inflation for a while and therefore I’ve got to figure out what my mix of business should be. And within that, there’s two types of business mix changes a management team can go through. One is, it’s time to take advantage of weakness in others and be offensive.

And so there are those who are really well positioned, long cash, maybe lined up exactly right for the kind of environment we’re in. And they’re looking at what they can find in the re-priced arena to be opportunistic in. I think we’re early there. Some companies are always sitting around with their business development, looking at 20 different targets and they’re ready to pounce right now. Others are just starting to do that work. So I’d argue that opportunistic kind of transaction, we’re probably looking at mostly 2023 in terms of we’re going to see those deals really start kicking in because folks are starting to kick into gear with that. The flip side, which I’d say the majority of companies are in, is they didn’t necessarily have the strongest position going into the selloff. And so they’re thinking more defensively, how do I highlight value? And so I generally think of that as the fit and focus in analytics, which is first, can I go to loan or do I need to combine with someone bigger?

We talked about that before companies coming together, real kind of typical merges of equals. But I think what we’re going to see as a disproportionately large part of the business the next 12 months is the standard fit and focus, which is I do two things really well, I have another business that maybe I’m not the right owner of that asset. It seemed interesting. I’m two years into the build, five years into the build. There’s another five years to go. I should sell that asset either by spinning it out and letting the shareholders that really want that to own it. And so I do a typical carve, spin, et cetera. I sell it maybe to private equity.

So the private equity owner can put more capital into it and finish in the plan. My existing business therefore is more highlighted for the public market by getting rid of a third wheel that maybe doesn’t make sense, or I sell that subsidiary that isn’t critical to a strategic partner and get value through the value of the synergies, et cetera. All those conversations we’re having with companies, we’re just not seeing that many of those being executed yet, because what we are in that cycle is we’re now at the point, people recognize it. They recognize it’s durable, they’re doing the work and that’s, I think second half this year into next year. I know Grant if you see it differently, but I can’t believe how much dialogue there is in that front. And obviously then, how do you change your capital structure to match that as well?

Grant Miller:

No, I totally agree. I guess. The only other interesting thing I’ll say is we’re seeing investors, public investors looking at many of their portfolio companies and seeing similarities and encouraging dialogue with respect to, is there an opportunity? We’ve seen investors actually put together symposiums of their portfolio companies to make those things more reality. I think it’s a long way to go before there can [inaudible 00:25:32].

Larry Wieseneck:

[inaudible 00:25:34] public [inaudible 00:25:35].

Grant Miller:

Exactly. I’ve never seen it before and so I think it’s really interesting. I’m not sure we’re there yet, but we’re seeing that kind of push to try to rationalize in that piece, which I think is really, is quite interesting.

David Erickson:

So we’ve obviously had a significant pullback already this year, but it feels like there’s probably a little bit more to go, whether it’s more activity from the Fed or other factors that could be driving things in the near term or through the summer, at least. How are you advising companies to plan their potential market activities for the next summer months?

Grant Miller:

Sure. I’m going to try to get a swing of this. Not obviously not an easy one. I do think that now the Fed is acting and acting aggressively. It feels better. It feels better because the anxiety around getting started is gone. We’re in the middle of it. And by and large part, once the economy has bottomed, wherever that is, generally speaking, the equity markets are already up and deals are already starting to happen. So it’s a really a leading indicator. And so the advice is really clearly, I don’t know when we’re going to see that inflection point, but when it comes, you have to be ready because if folks start making money in these deals, they will start to happen very aggressively. And we know based on our pipeline, many companies are waiting for that to happen. And I’ll just give you a couple, maybe a couple anecdotes that could help hallucinate that point. I went back in time and looked at, when deal activity has this been this low, and I’ll just generalize and say, basically five deals per week across all public types of financing is a very low level.

We’ve seen that a few other times in history, in the.com era, in their early two thousands. When we were at five deals a week, it took about six months and we were at about 10 deals a week. So, six months and we doubled deals. Both in the financial crisis and then during the COVID pandemic, the snap back was much more aggressive. By the time we were doing five deals a week after financial crisis, six months later, we were doing 20 deals a week. And similarly, we were doing five deals a week, right after the pandemic. Within six months, again, we were about doing 20 deals a week. So I don’t know when that inflection’s going to hit, but when it does, the activity level will likely double or more likely could be quadruple if those historical trends stay. So you need to be ready to take advantage of that market activity.

Larry Wieseneck:

That’s a great point, Grant. I’d say the one thing I want to make sure we are not minimizing is just how much pain there’s been, right? We’re talking about an extended period of, to Grant’s point, 5 deals a week, that’s the deal market. What that means from any social investor standpoint is that we have some real carnage in the investor universe. And we’ve seen as is needed by the way, for the market to go through a proper bear market. We’ve seen significant hedge funds shut down, literally open on Monday, closed by Friday. We’ve seen periods including maybe going back last week, well, week and a half ago that Thursday and Friday, where the market felt like it was in complete free fall, never seen more hedge fund selling, which included some guys being liquidated and shut down than in that period.

To me, while those are painful in the form of kind of the destruction that’s needed to rebuild, that’s actually encouraging for finding a bottom in CAPA markets activity. And by the way, doesn’t mean a bottom in the markets. Oftentimes CAPA markets activity does pick up before we actually have put it on bottom. The key is it’s what brings volatility down to more manageable levels because that for selling correlation of one, everything going down, when that goes away, you can start to see deals come together because volatility goes, gets lower, companies can at least have a confidence that if they launch a deal on Monday, they actually can price it when they get to the pricing time.

So I agree with Grant. I think we’re getting closer. I wouldn’t, and I hate to say this cause I don’t wish bad things on anybody, but I think for the market health, there might need to be a few more folks who are over-levered a little bit too much all in, who get carried out before we can say it’s safe to go back into the water, but we are a lot closer now than we’re in February. And it does feel as if in the second half we’re going to see an increase in deal flow, just don’t know how much.

David Erickson:

So we’re coming close to the end of our time. And we’ve talked about a lot of challenges in the market, but before we go, I wanted each of you to kind of talk about some of the bright spots that you’ve observed in recent months as we end the podcast.

Grant Miller:

Yeah. I have a couple, well, maybe even a few. I think that the investors we speak to have set themselves up for recovery, meaning many have more liquidity and are interested in getting back in when the water seems okay to do so, as Larry just commented on. And so where I see the beginnings of that already is in or at the market front range, where there are these beaten down companies, we are seeing an increased flow of saying, “Hey, this looks really interesting would they sell?” Would they sell to this level? Now many aren’t saying no, but it’s an indicator of real interest to come into new stories. And then the second is actually a conference that we just conducted and Larry can come in to this, he was there, I was able to make it, but we did the first ever conference in what we call a healthcare revolution, which is really a way of combining a lot of what we’re doing in tools and diagnostics area, which is really a… It’s almost a too narrow scope to describe, but what we saw both by side.

So we had investors there and we had many of our clients there. People wanted to be there, talk and so goes back to what I started. Talk to one another, see where the opportunities going to be, really dig in. So when things start to look a little more promising, they know where to go and there was a real excitement to be together and to understand what’s happening for this next stage, because in these areas of high innovation and that’s really what we bank high innovation, is that you need to have that heavy content level to make sure that you can get into to the right investments and be able to sell to the right investors. And I think that is a highlight that conference of getting people together, as a precursor for much of the activity.

Larry Wieseneck:

Well, I’ll just say, as Grant mentioned the conference, I totally agree and I heard someone there make a comment that echoed. And so these are public market, generally public market investors and companies that were there. It was a public market investor who talking about the space, made a comment that was almost the same as I heard from a private equity investor last week, talking about what had been going on last year in certain parts of private equity, both used the term, “we’ve gotten rid of the flippers,” and what they meant by that was the analogy to in real estate when generally if you buy a home, you’re buying it because you want to own it for the long term. When things get very frothy, people buy a second or third home as an investment, because they think you can buy it today and flip it six months later and they don’t need to actually worry about the fundamentals. What we’re now at because where the market is, we’re in a fundamental market.

So the folks who really know healthcare and have invested the time they’re relieved, they don’t like what’s happened to their portfolios. But they’re relieved that folks who didn’t really understand the space, didn’t put the time in, but were often coming in and pricing up names, they’re gone and they’re gone for a while, right? So the real guys who do the homework are the ones who’ll be making deals happen, partnering with companies, same thing we’re hearing in the private equity space. They’ve gotten rid of some of the fast money that maybe was coming in and distorting valuations and the same thing in the venture world. I had a conversation with a fairly sizable venture fund who was predicting that the money that you’ve been putting to work in the last three months and the kinds of deals they’re seeing right now will be by far their best year of investing in the last seven years.

Cause what happened was, again, the renters pushed out, they’re real owners. They love the space. They’ll be with these companies for the long term. And so it’s their kind of market. So I do think that’s a bright spot, which is when folks who do the homework and really understand the space, start to want to invest again, that’s when you start to rebuild and we’re right there. And so I agree with Grant entirely. And maybe with that, what I’d love to do is just first as always Grant, thank you for joining when we do these calls. David, thank you so much for hosting. We feel very lucky to have you as our moderator of these conversations. I hope that both of you and your families have a great July 4th weekend and again, to all of our listeners, same to you and let’s hope for a really productive second half of the year.

Speaker 1:

Thanks for joining us. Stay tuned for the next episode of Cowen Insights.

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