A Strategic Review Of The State Of The Capital Markets In Q4 2022 & A Look Toward 2023

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In this episode, Cowen & Company Co-President Larry Wieseneck once again joins David Erickson, Senior Fellow at Wharton Business School, and Grant Miller, Head of Cowen’s Capital Markets Group, for a follow-up to their Q3 podcast. Like that 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?”

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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 podcast.

As always, I’m here with my good friend and former colleague, David Erickson, senior fellow at the Wharton Business School, and my colleague, Grant Miller, Cowen’s Head of Capital Markets.

The three of us last sat down to discuss the state of the capital markets at the end of the third quarter, and now with 2023 fully underway, we’re ready to not only review Q4 of 2022, but also take a look ahead. So, David, once again, I turn the table over to you.

David Erickson:

Great, thanks Larry. Last year on our podcast, we started with the question, where do you think we are now, and how are you advising companies to prepare for the near term?

Obviously, we seem to be closer to the end than the beginning, unless you’re a Jets fan, Larry, as we talked about a few months ago. I don’t know, Grant, if you have some thoughts on that bet that we talked about, I guess a few months ago.

Grant Miller:

So, Larry, what’s your summation? Now that we’re recording, is actually just after the divisional series. So now after both your Jets and my Patriots didn’t get close to sniffing the playoffs, what are your thoughts?

Larry Wieseneck:

I’m looking at my feedback of the quote from the last time, and I’m not feeling great about what I said then. Next year, hope springs eternal, is the way I think of it. We’re a quarterback away, Grant. I don’t know what to say.

By the way, as we saw in the playoffs, again, it’s all about the QB play. And so, the Super Bowl’s going to be great. I think it’s two exciting teams with two great quarterbacks, and I’m just looking forward to, once again for five decades running, I’m watching at home just hoping for a good game.

Grant Miller:

So I’m actually trying to gloat, because I have nothing to gloat about this time. In fact, I’m a little sheepish, because the next time we record one of these, the baseball season will be underway.

Larry Wieseneck:

And then, you’ll ask me about the Red Sox.

Grant Miller:

Between the pitchers and stoppers. And Dave, what we need is not a quarterback but we need … Well we might need a quarterback.

Larry Wieseneck:

One long ball hitter.

Grant Miller:

We need pitchers.

David Erickson:

Yeah, I noticed that. But pitchers and hitters.

Larry Wieseneck:

All you really need is guys to play the field. Some hitters and some-

David Erickson:

We need nine players that can play the field.

Larry Wieseneck:

But other than that, it’s not a big deal. But it does bring us back to capital markets, and where we are. So I think David, when we talked a year ago in particular, we were anticipating that the Fed was going to have to start to get aggressive around what appeared to be impending longer term inflation risks. And I think, we’re in a very different place today. I mean, we were talking then what will the hikes be? Will they be aggressive, will they get ahead of it, et cetera?

And I think, here we are with what has been over those last 12 months, historic in terms of the amount of increases, in terms of speed and aggregate amount. And so I think that the only way to look at this is that we’re closer to the end of, at least this version of Fed rate increases.Doesn’t mean there won’t be a pause at some point, and that we might then find ourselves for different elements of the cycle, that we wouldn’t see another regime of rate increases. But we’re towards the back end. I don’t know if we’re 75%, 80%. Certainly the bond market telling us that we’re pretty close to the end of that.

I will just say though that I think the Fed has more than ever before, been using their words to tell us what they intend to do, and that they’ve been following with it, meaning following their words. And I think we should take them very seriously about this, which is they’re going to err on the side of greater caution, rather than less. Meaning I think, they’re likely to tighten one or two more times than the market wants them to, and it will probably end up with a Fed Fund rate that’s a bit higher than where the market will need it to be. I think they’d rather err on that side and get inflation under control, and then quickly release and come back down again in terms of rates, rather than continuously be behind and find themselves in the situation we had in the eighties. I think they’re focusing much more on what happened in the late seventies and eighties, than they are anything since then. And so, that would be my focus thing. We’re towards the end, seventh inning for using the baseball analogy.

David Erickson:

So Larry, let’s talk about the market in the context of, last year was difficult. So for a company today who needs to finance, they didn’t finance last year and they probably need to finance the next six months, what’s the advice today?

Larry Wieseneck:

I would say that we find ourselves again in a theme, David, that you and I have talked about on these podcasts for multiple years, which is we’re in a world of haves and have nots. Those who either were long cash going in, or were very aggressive to make sure that they were conservative on their spends and that they maybe even raised capital in what was an increasingly hostile environment, but yet they did it. They have the ability to control their destiny. And they’re in one camp, in the camp of the haves.

I think those who went into the last 12 to 18 months, potentially slightly under capitalized and then didn’t get in front of it, are finding themselves in a more defensive posture. And so I think when we look at the world, we think of it as kind of defensive versus those who can be offensive. Doesn’t mean when you can be offensive that you should be, but those are two different camps and there’s different answers for both. So Grant, why don’t I turn it over to you, because you obviously spend more time on those daily conversations than I do.

Grant Miller:

So, a little bit of the maybe bottoms up, in terms of what we’re talking to clients about, I think it goes into really three categories of thoughts. One is plan, two is be ready, and three is be in the moment. So I think that in terms of the planning, that’s contingency planning. That is with management teams and boards for good scenarios and ones that aren’t so rosy. We saw a lot of that going through last year, where companies have looked ways to cut, burn, or change programs that are in the biotech scenarios where they’d be able to extend runways. So the six months, Dave, you noted, I actually think it’s quite a bit longer. Albeit, people are looking for too in the investor side, two years of runway of capital where that might have been a year, or to 18 months. So I think planning on both the upside or the downside.

Second is be ready. So, with regard to finding investors where you might not be able to see them, we go back and look at proprietary data that we have with all aspects of our trading activities and our corporate access activities, to make sure that we’re targeting the correct investors. And that be ready is also relevant to what’s happening in the market. The beginning of last year to the end of last year, the first and second six months, biotech instruments for example, doubled from the first to the second half. And so when folks couldn’t get deals in the first half, they had to be ready to be able to execute those in the second half. And that actually even was more dramatic in the last two months, November, December, where the markets did open for other issuers as well. We did 15 book run transactions, seven on a lead basis in those last two months of the year, more than any other firm. And I think it was a lot about, because we were ready with our clients, to really jump in.

And the last advice is, be in the moment. So maybe a couple case studies. One of our really good and long time clients is Horizon Therapeutics. They have been recently, was announced to be purchased by Amgen. We’ve done many, many transactions with them over many years. In 2012, I think this was the second or third deal after their IPO that we led for them, they had a really tough deal to do. They did about a 30% discount deal raising $90 million. At the time, their market cap was about 150 if I recall correctly, so that they could get to the next stage and continue to develop. That was a hard pill for them to swallow, but that was the one they needed to, to be able to get to this stage, where they’re $110 a share and they’re a $30 billion acquisition by Amgen.When I congratulated the CEO on the acquisition, he’s been there all this time, he reflected on that moment, of the be in the moment and what you need to get done, so that you can live to see another day.

And then with regard to what maybe more recently, we did a transaction for a company called Aspen Aerogels, where other banks, they had a very large CapX need of, they had announced a $575 million and a 500 million market cap, which seems like an impossible task. They actually tried in the middle of the year to do a dual tranche common and convertible with other banks. And that deal failed or they went to the market, their stock was done 40% and they pulled the transaction. What we tried to do is get them to piece deal parts of those, that deal together. And so the end of the day, what they did towards the end of last year is they used the ATM we had in place with them as one piece, they were able to bring in a strategic investor in Koch Industries, they were able to get credit backing from one of their customers.

And so the very last piece was the equity to fill in this kind of last piece of what they really needed. And we launched a $200 million deal launch and priced almost 300 million. And so those pieces of either, nobody likes their price potentially at the moment, but to get what you need to get done and find your ways through the capital markets is the last piece. And I did mention that last case study of at the market programs or ATMs, last year, we saw our clients use that extremely effectively, to be able to bridge gaps to the next time that they can have a broader financing window to be able to go out. So maybe those are the three components of the advice we’re giving clients.

David Erickson:

Thanks, Grant. Since we’ve had a nascent IPO market for the last year and hopefully things will improve this year, what do you think will be the types of companies that will come first? How will that market develop?

Grant Miller:

Sure, I’ll take that one first. So, nascent is like a euphemism, Dave, that’s the nicest thing you can say about the IPO market. Obviously, we were off the highs of ’21 where everything was working, and then we hit ’22 when the volumes are even 50% lower than the 10-year averages and medians. And so what I think is that’ll come back first is companies that are lower beta, companies that have really good growth but also have some stability to them. And actually the IPO market and the backdrop has been growing. The filings have, both confidential filings that we’re seeing and hearing about, as well as the public ones are certainly growing.

The biggest part of the IPO market has been over the last number of years, the biotech market and healthcare market. What we’re seeing there is still a market that’s not functioning perfectly. Those deals really need to be fully subscribed by existing investors, to give new investors interest to be able to come in and be essentially, a safe investment in those IPOs. We haven’t necessarily crossed that threshold yet, but I do think those opportunities are going to come.

I also think there are some signposts to what could end up working. The first piece is existing public companies need to be able to get financed more seamlessly at reasonable discounts, and then very importantly, make investors money. So we’re starting to turn the corner there but unless and until follow-ons and IPOs actually make investors money, there’s going to be some reticence. The Renaissance IPO index last year was down to over 50%. Who’s going to invest in IPOs when that asset class isn’t really working? So we still have some ways to go, but there certainly are avenues and companies that will be able to go there.

And I’ll put out one very successful IPO, which I think is potentially a trendsetter, which is Mobileye. So, it was one of the largest tech IPOs last year. An interesting case study because Intel had taken it private, about $15 billion of value and then was going to re-IPO it, and the rumors were very high valuations. They ended up taking it back out at about the same price as they took it private in ’17. And so, since then what’s happened, the stock went from about 15 billion of or 16 billion of value to 29 since it went public.

And so basically what they did, what Intel did, and this might be assigned to what we see sponsors be able to come back to the IPO market, is be able to sell a modest size of the overall entity. In this case, there’s only 6% of Mobileye that got sold in that IPO, at a price that actually does make investors some money. Gives them that level of confidence to come in and support the company, the IPO, and then going forward. And now at a 30 billion, Intel’s looking pretty smart, because they sold a modest piece and they have the capital, and they have the backing with a broad institutional owner base. It’s, I would say, a little bit of maybe of a un-Bill Gurley approach to the market. But I do think that’s where we are with respect to getting the IPO market reopened in a positive way.

Larry Wieseneck:

Dave, I think that what Grant just described about the IPO market is actually equally applicable to any market that either shuts down or comes close to shutting down in a difficult environment, which is that the first deals that get done, have to get done well. And for that to occur, you need to have some form of in inducement for investors. And when those perform well, then others can come at tighter discounts. And again, when I say discounts, I mean whatever the market is. In the IPO market, it’s to fully distributed. Obviously, as we think about the bond market, it might be where reference rates are, et cetera. But I think that’s what 2023 is going to be across many of the capital markets, which is a need to see those who move first, be a bit more a conservative, and therefore provide a bit more incentive. And then over time, we’ll see tightening.

Grant Miller:

And the only other thing that I would say is with regard to the IPO market is, we’re taking a book out of, Dave, your old Lehman Brothers book, which is we’re doing a lot of IPO boot camps with companies and the management team. So that maybe it’s not in six months, maybe it is in year, 18 months or further, but being able to be prepared for those moments on the IPO is really what we’re thinking about now.

David Erickson:

We’ve talked about the IPO market, we’ve talked about kind of changes in terms of the market environment. This week, we’re actually recording this before the Fed announces their latest rate change or not rate change, but clearly there’s been significant rate rises the last nine months or so. It’s obviously had an impact on the debt markets. How are you seeing the middle market, sponsor market, back market today?

Grant Miller:

So with regard to what we’re seeing in the sponsor markets, and it’s not just middle market sponsors, it’s also large sponsor transactions. While the syndicated market has been very, very quiet, although there is some rebounding in 2023, even going to the private markets. And so that is both with regard to middle market sponsors as well as large deals. So both Thoma Bravo and Advent for example, when there are two recent transactions went to, exclusively to the private market to do deals that were billions of dollars each. And so I think that is a trend that has been and will continue to persist, and that maybe the broader scope of that is if you look back at a decade ago, the private credit markets were about 2% of the overall financing markets. Today, they are 20 to 25%. And so while the syndicated markets are pushing back a bit, there are other avenues to be able to get transactions done for sure.

David Erickson:

So in the last couple of podcasts, we’ve been talking about some of the deals that have been done in the private market. And given the market turbulence that we had in 2022, can you give an update on some of the types of transactions recently done and expected in the near term?

Grant Miller:

The last question even before I go there, just thinking about some other deals that we’re been seeing and hearing about, are actually sponsors, particularly middle market sponsors, are doing transactions with all equity. Waiting for the financing markets to be able to come, and then going in and going through the financing. And so that’s an extreme example, but I would say over equitizing is another trend, so that to avoid some of that piece.

Yeah, so maybe just on the broader private market. So we look at it, everything private, so we call that effort our private capital solution. So it’s everything from equity to debt. Maybe we’ll just, I’ll start on the equity side and so last year was a tricky year. We did about a dozen private equity placement transactions between about 40 and $200 million of proceeds. I think the trend there is that they’re taking longer, because when you have evaluation reset in the public market, private market valuations tend to be sticky, because you don’t market every day, and so the boards don’t see the value of their true comps and what that really looks like. And so they have become longer and tougher.

It’s particularly hard and we have over that number of live deals in the market right now. Finding a new lead investor to come in and put a stake in the ground around evaluation, around terms, and frankly by expectations and looking at it from a fresh perspective. So more structure, longer terms, longer time of completion and harder to get real leadership. That doesn’t mean the deals are not getting done however, so we’re still able to get them done. But I do think that the bar for investors continues to rise based on what we’re seeing. It’s a waterfall effect, starting at public companies and going right down to the private market.

The other piece of the private market that we haven’t really spoken about is, one area in healthcare that’s been a real transformation I would say. Which is while equity has been harder to come by, many of our clients, particularly ones that are a later stage, have been turning and doing non-equity financings. Everything from private debt and term loans to selling royalties and financing synthetic royalties. And so it kind of runs the spectrum from a temporary financing vehicle like a cadet deal to other forms of permanent capital. And instead of equity, we’re selling either a piece of that drug, or a royalty that they have owed to them.

And so, because of the length of time and remember biotech started to fall out of favor well before the rest of the market. That peaked in the middle of 21. They’ve had a longer time to deal with trying to find different interesting solutions in the private market, to be able to fill their coffers. And I think that’s really what we’ve seen. And where I see it going forward maybe in this is, I would say semiprivate, which is the convertible market, where we really haven’t spoken to it in a while and maybe I was a little early in that prediction last year. But today, while we have rising rates, and we have an equity market that’s not quite ready for every issuer, that looks tailor made to me to have an increased issuance in the convertible market, which is of course a hybrid between the two.

Larry Wieseneck:

David, one thing that I would just add about the private market activity is I think, very similar to what we saw in say early 2020 at the beginning of the pandemic, where both VC and private equity hold investors had to focus on their portfolio first and hence weren’t looking at new names. I think we’re in a similar circumstance because of the different exogenous event. So that event was the pandemic. The event of interest rates as you said, and inflation has created, or trying to get ahead of inflation is what’s created the period we’re in today. And part of the problem is, it’s not just that in the funds are concerned about quote, unquote, “Reaching,” and, “Can they get to the right price if, what’s the right EBITDA offer next year, and I don’t want to overpay for that.” And so, I think some of that concern from ’22 might be burning off, and ’23, we might start seeing buyers and sellers meet.

I think a more basic issues been going on, which is they’ve got to worry about the portfolio. So the best stewards of capital recognize that even though it might be a great time to put capital to work as things are repricing, the first job is make sure your current portfolio survives well, right? And that you are leaning to your portfolio companies as appropriate. If there’s situations where those balance sheets need to be strengthened, you better do that. Because if you think of it from a fund manager, again, whether it’s a middle market fund, a larger fund, I’m on fund five, I want to go out and raise fund six, the most important thing is that you’re being challenged right now as a fund manager on the performance of your existings. And it’s their obligation to deal with those first. So one of the things we’re seeing is a lot more focus on recaps of existing portfolio companies.

Some of the things that we might talk about in the public market, we’re seeing for private market companies. If I’ve got a business that’s in three areas, maybe they really should stick to two and we’ll sell one of them. So part of the activity level we’re seeing that’s percolating here, is this question of, “Do I have the right balance sheet for the businesses I own? If I love the asset, rather than buy someone else’s asset now, maybe I actually should go and re-up around that name,” and that’s created a significant increase in secondary transaction in particular, in continuation funds. So if there’s one theme that we’ve seen picked up in the last year, it’s private equity funds looking to raise a continuation fund for the existings they want to own through the next cycle, rather than selling it into a market that’s challenging. So that’s been a big pickup.

David Erickson:

Yeah. Larry, you might want to just touch a little bit more granular on the continuation funds, just by way background, so people have that context.

Larry Wieseneck:

Sure. So a continuation fund is usually, although not exclusively, but it’s often set up as a one-time special purpose vehicle to purchase a asset. Let’s just use an example. It could be a private equity fund has a number of assets in an existing fund. It’s in the eighth year of that fund, let’s just say. And the opportunity for that business continues to be pretty robust. With a fund life of 10 years for your average fund, they either need to begin to think about monetizing it, or they would have to do an extension. So what often might be the case is the best opportunity, particularly if some of your existing investors would rather get money out at this point, rather than stay in longer, would be to consider selling the company.

And when you begin the process of thinking about selling it, you also set up potential for a continuation vehicle to be the buyer of that. And a continuation vehicle would have your investors that choose to participate in that deal. It could be many of your existing investors from the current fund. It could be investors that might be coming to a future fund, it could be other third parties. But the point is, that the manager gets to continue living with that asset, but with new owners who signed up for that opportunity. And that’s really, that’s something that we didn’t see very often three or four years ago. Now it’s happening very often. And again, one of the reasons for that, David, is because in a market where it’s hard to find financing to what Grant said before, and where it’s hard to figure out the right price, if I know the asset so well as a manager, I’m very comfortable with potentially continuing to manage that asset for the next five years, seven years, whatever it might be. So I set the continuation vehicle to run that.

David Erickson:

Thanks, Larry. So let’s shift gears a little bit and kind of shift from capital markets, and focus on M&A for a bit. Just like the capital markets last year, obviously the M&A activity was pretty quiet last year as well, but some firms are out there forecasting a recovery in 2020, or sorry, 2023, excuse me. What areas are you seeing the most traction currently, and what types of transactions are getting done in today’s market?

Larry Wieseneck:

So I think that I’ll start with what I just mentioned a second ago, which is, I do believe that we’re seeing a lot of would be M&A transactions turn into continuation vehicles, particularly, obviously in the private market. That’s one theme. So they still are considered a sale, but it’s going from a fund that was managed by X, Y, Z private equity investors to another fund managed by them, happens to be a special purpose vehicle. I think we’re also seeing a significant amount of deal flow that I think will pick up this year, which is a reallocation of assets, if not whole companies. So that’s trading of assets from one owner to another.

Think of that as in the most simple form. If I’m a real estate company and I’ve got hundreds of assets, I might decide to shrink my portfolio on the West Coast, sell that to a West Coast entity that wants to get bigger in the West Coast. I haven’t really sold the business. I’ve sold assets from one player to another. We’re seeing that in healthcare, in terms of whether it be drug portfolios or individual names. Grant can certainly talk about that. In the biotech spaces, folks are thinking about different platforms that they might be trading.

So the first thing is, asset level activity tends to always pick up in challenging markets before whole company transactions. A version of that in the public market is we’re definitely seeing companies that had gone public in the last five years, that possibly would be better off being restructured, or even changing their focus by going private again and cleaning up in the private market. That could either be done directly, it could be done in some form of a sponsored spin. So either the whole company goes private, or a portion of a public company gets acquired by a sponsor to be managed differently. And then the third is just being sold from public company to public company. And so, we’re certainly seeing divisions that may not make sense in the larger public company, being sold either the private market or to another public company as they restructure their business mix. There, that wouldn’t be an asset per se, but an actual company. A division being sold to another business.

David Erickson:

Thanks, Larry. So given you’re always optimistic as a Jets fan, looking forward, what do you see as one or two bright spots that we can, when we have another session in a few months, what were some of those bright spots that propelled us forward?

Larry Wieseneck:

So I’ll start with, I’m not sure. Well, first of all, I’m glad you say I’m always optimistic as a Jets fan. I feel like I just see things through green eye shades. But in terms of the market, I do think that the Fed, I started with earlier, the Fed has done a good job of setting expectations, that they’re going to be very aggressive and continue to be as it relates to rates, because they had to make up for the fact they were behind or perceived to be behind 18 months ago. I think that’s set the market up such that, I think there will be a time, and I don’t know if it’s two months, four months, six months, eight months, but it will become clear that they were able to get hopefully, inflation under control. And in that scenario, I think that the positive move will be, they will then be able to take a pause. And that will be a positive for the market overall.

I think the market keeps trying to predict when that will happen. And we see these periods of, particularly the stock market trading particularly well, and then retreating. I do think it’s going to be hard to predict when that’s going to be. So for someone who wants to say the bottom was put in, in November, December, whatever they’re trying to say, and certain markets, we look back, if we look at healthcare, we can look back and say that the market at bottom might have been put in, in certain parts of growth healthcare in May or June of last year.

I’m not ready to call the bottoms yet, but I do think that there’s this perspective that we have, that we’re in the seventh inning of the tightening cycle. Maybe it’s the eighth, we just can’t predict when. I think that’s a reason to be optimistic, because I think that when it becomes clear that inflation continues to be getting tempered, I think that the market will be favorable and deals we’ll be able to get done with a much more stable environment. Because the one thing we didn’t really discuss before, we’ve talked previously, is volatility is the enemy of deal activity. And so, decreased volatility is the friend of activity.

Grant Miller:

Maybe I’ll just add on to that, Larry. I completely agree and maybe I’ll just take it from an issuance standpoint. I think the market is actually starting to react to news in a logical way, or more what I say is a logical way. And so, that started in healthcare last year. The beginning of last year, good data was being, stocks were going down. That stopped second half of last year and issuance went up. We’re also seeing that now in the tech sector where those valuations are actually starting to rebound. And so, growth is outperforming value right now, at least for the time being. Maybe there’s a bit of a short squeeze element to it, but nevertheless, you’re starting to see some normalcy.

What Larry said is absolutely true. We don’t need the markets to be higher, we just need to be stable. Some of our traders are telling us, the reason why we’re seeing this uptick in tech and the NASDAQ is because it’s been quiet on the Fed front for the last couple weeks, and just that level of quietness will let things come back.

And maybe the last thing I’m optimistic about is, it is a little bit of a canary in the coal mine when I look at our ATM practice. These are investors that are coming to us, asking to buy stock off of our programs. In Q4 and continuing to this year, we’ve seen large neutral funds come back to us, to asking for stock in these programs. I believe that could be the beginning of having them looking for more activity going forward. But I agree with Larry, I’m not going to be so bold as to try to project the actual timing.

David Erickson:

We’ve covered a lot of ground today. I think we’ve pretty much exhausted all our time. I’m looking forward, a few months down the line, to kind of check in and see how things are progressing. Thanks for both of you joining us today. Larry, I’ll let you finish off here.

Larry Wieseneck:

Well, David, let me first thank you again for joining me and Grant. We always enjoy our conversations with you. And let me thank our listeners. We appreciate you and look forward to the next time we’re together.

Speaker 1:

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


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