The Do’s and Don’ts of Analyzing Tech IPOs
2019 may turn out to be a banner year for initial public offerings (IPOs) in the technology sector, with several unicorns – companies with a private valuation of more than $1 billion – expected to join the public equity markets. Denny Fish, Portfolio Manager of the Global Technology Fund, explains how considerations such as voting rights, valuation, growth outlook, unit economics and management’s record on capital allocation influence his investment choices.
The Do’s and Don’ts of Analyzing Tech IPOs
- The bar to invest in companies before they go public is extremely high.
- Tech companies are no longer rushing to market but are staying private for longer, which impacts the calculation of potential returns.
- When deciding to allocate capital to an IPO, it’s critical to assess the potential impact on overall portfolio risk and construction.
Dex McLuskey: Good morning, good afternoon, good evening and welcome to the Janus Henderson podcast. I am Dex McLuskey. Initial public offerings, or IPOs, have been a consistent recurring theme in the news this year with a number of so-called unicorns – private tech companies with a valuation in excess of $1 billion – generating lots of media and investor excitement over their plans to sell shares to the public for the first time. But the headlines mask a few key stats.
According to Renaissance Capital, which markets IPO-focused ETFs, the deal-making year got off to a relatively slow start, with 34 IPOs priced in the U.S. in the first quarter of 2019, about 38% fewer than in the same period a year earlier; and where the amount raised from those sales totaled $9.5 billion, almost half of the first quarter of 2018.
But with more large deals expected to be priced in the coming weeks and months, there is a buzz that 2019 could be a banner year for IPOs, especially in the tech arena, which suggests that our guest today, lead Portfolio Manager on the Janus Henderson Global Technology Fund, Denny Fish, is going to be even busier than usual. So being considerate types, we thought we might add to his burdens by inviting him to share some of the thinking that goes into deciding whether to take part in or to pass on a deal. Denny, I appreciate your time is precious, so welcome, and thanks for taking the time to talk with us.
Denny Fish: No problem, thanks for having me.
McLuskey: So let’s start by looking at the pre-IPO companies. I am wondering, do you ever invest in private entities and, if so, what are your criteria for doing so? And, moreover, how do you track and assess the performance of valuation in the absence of objective and comprehensive market and financial data?
Fish: Yes, so we do have the capabilities to invest in private companies. Generally at any given time in the Fund, we will have a small number of private investments, so it is a part of our process. We actually meet with a lot of private companies because it helps to inform our views on the competitive environment for the companies that we own in the portfolio, particularly around the Optionality sleeve in the portfolio. What do we look for? We are generally looking for companies that have demonstrated to us that they are likely to hit escape velocity from the private markets within an 18- to, say, 24-month period. The businesses have achieved enough scale to where they really only need one more round of financing and, in some cases, they don’t even fully need that round of financing, but they want the cushion and they also want to start developing the relationships with institutional investors to prepare them for going to the public markets. What we look for also, most importantly, are very durable businesses that in a perfect scenario we would make that private investment. A year and a half to two years later they go public, accept a meaningful allocation on top of our private investment and hold that investment for the next five years, and it can be a very meaningful contributor to the portfolio. For those conditions to manifest we need to do a lot of work on the front end; we have to understand the competitive dynamics; market conditions have to be favorable and, most importantly, we have to get the business model right, competitive dynamics, as well as assessing – we tend to try to invest in management teams that tend to create value in new and unique ways that we can’t predict. And so we also look for companies that have already started to do that in the private markets as a demonstration to what they may do as a public and maturing company.
McLuskey: Right, that sounds like a pretty high bar. I mean out of 100 that you study, how many would meet those kinds of qualifying criteria?
Fish: Maybe five.
McLuskey: Really? So it is a very high bar.
Fish: It is very different than, say, venture capital investing. So in venture capital investing, you may do 10 investments and three or four of those investments may be against a similar theme or business idea. You just don’t know who the winner is going to be. But what you do know is if you get two of those right and they are up 10x or 20x that it compensates for the other seven or eight investments that didn’t pan out. We are trying to be very, very selective and that is why we do later stage whenever we do them, so that we have more confidence that they are coming to the public markets in a daily liquidity product like we operate.
McLuskey: Right, I got you. So when one of these companies does decide to go public – or any company, not just one that you have invested in in the private realm – what are some of the factors that drive your decision to participate? I’m thinking about things like whether management is selling, how much they are selling, the total size of the offering, the structure of the, the share structure after the sale voting rights and liquidity. Do these things all come into the mix for influencing your thinking?
Fish: Yeah, I mean in a perfect world it is a really good business with defined economics that we can understand; very defensible business model, a history of, say, cohort analysis where we can see multiple years of data on how customers, whether it is an enterprise business or consumer business, has actually behaved over time. We ideally would like to not invest in controlled companies, but the reality is many of these companies are controlled and so it is…
McLuskey: Just explain what you mean by that.
Fish: Yeah, there are structures that can be put in place for founders – effectively only own, say, 10% of the shares of the company but they have 70% voting control. Meaning that they effectively are going to make all the decisions, and, as minority shareholders, effectively we are not going to have any ability to actually truly influence any decision making. That has worked out really well in some cases. Google or Alphabet is a great example of where there has been a lot of value. Facebook has created a lot of value. And also other situations where things haven’t worked out as well. Snap is a perfect example of a situation that hasn’t worked out since going public. And there is no chance to actually influence the Board or management in those situations.
McLuskey: Or the direction of the company, right. So let’s just take a quick look back to where we are now. I was checking some stats and if you look back at the late 1990s – the era of the dot-com boom and bust – back then, IPO activity was just frantic. There was something like 2,400 share sales from 1996 to 1999 in the U.S., raising about $200 billion that mostly, if not entirely, disappeared. And that is according to Thomson Financial Securities. Flip forward 20 years and companies are now staying private for a lot longer. They are not rushing to market the way they did back in the 1990s. What are the positives and negatives of that?
Fish: Yeah, so there are a couple of dynamics at play. I will talk about why that has been the case and then what some of the implications are. If we go back to 1998, 1999, 2000, you had the promise of what the Internet could be. So effectively, it became highly speculative. You didn’t have an environment where, compared to today, where mutual funds, like ourself, Sovereign Wealth Funds, all different types of capital pools that are available for late-stage private investments, even early to mid-stage for that matter. You know, areas that traditional venture capitalists would fund first round or second round, like in the late ’90s, but then the company had to go to the public markets to actually get the capital that it needed to continue to grow and to operate. And what many of them found out was they continued to operate in the way they had been operating as a private company and when the next round ultimately came, as a public company, they couldn’t raise capital again; they either were acquired or went out of business, merged. So it was different.
So if you kind of go back to the mid-2000s and think about a number of these companies that were formed during that period, and some that were even formed during the financial crisis, coming out of the financial crisis, there was just more of an availability – I am not exactly sure why – but there just started to be more capital that was freed up for these companies to get later-stage capital. And the answer might be that we were then starting to see how big these platforms could get and the amount of capital that they needed, but that investment capital was well worth it because of the network effects associated with these Internet platforms. So I think, as a result, investors have been more comfortable funding these companies, but what it has done is it has allowed these companies to operate privately much longer than they would have historically.
Therefore, the implication is a lot more of the value in the company’s life cycle is accreting to investors in the private markets than in the public markets. So if a company is coming at a $50 billion market cap, for example, that is very different than a company that comes at a $5 billion market cap when it was one-tenth of the size than it was when it ultimately comes public. And so we have had a lot of M&A in the public markets, we haven’t had as robust of an IPO environment. We expect a more robust environment, but the companies that are coming, they are much bigger businesses, they are coming up much higher valuations and more of the value has actually been captured in the private markets versus what may allow public market investors to compound returns.
McLuskey: Is it surprising to you that both investors and owners and employees, who are compensated in share options, are willing to wait longer or willing to delay that gratification for a lot longer? Is that something that is a surprise?
Fish: Yes and no. I think what is different is the type of companies that have been able to prolong going public have been able to raise capital. Whatever industry classification they are, GICS code, most of them are tech-enabled companies and they are mostly hiring for similar skillsets to differentiate their businesses. These are positions that tend to actually be fairly well paid: software development, data science, a number of categories where if you are an employee and you hold equity but you are also getting really good cash comp, what does it matter to you if it is this year, the next year, the year after? Difference to the late ’90s, where cash comp was very low in a lot of cases and there is a much higher equity, a very speculative equity component in many of these companies. So I think that is a different dynamic today. But in the end, these companies do ultimately have to come public because they need to give their employees some sort of liquidity.
McLuskey: Yeah, or risk losing them.
Fish: Yeah, exactly.
McLuskey: OK, so let’s look at some of the fundamentals of businesses that come to the market. Are there specific metrics that you look at? And I am thinking particularly within the tech market just now because many of these companies aren’t currently profitable when they come to market and some won’t be for some considerable time. So are there different economics that go into assessing these deals than, say, recently Levi Strauss went to market again and it is a very predictable, very mature business that has got very visible unit economics. How does it differ for you assessing a company that isn’t currently profitable?
Fish: I think most of the growth companies that come to market through the IPO process right now aren’t profitable. And it takes a lot of work and you have to have a lot of history in the subsectors of technology. So whether it is enterprise software, cloud-based businesses or if it is consumer Internet businesses or if it is marketplaces, each of these has unique attributes. And we have invested in all of these subcategories for several years and so there are things we look at to, most importantly, assess for a dollar spent – in the most simplistic manner – for a dollar spent, what is the return that you are getting on that dollar if you are losing money? And that can be a function of churn and cohort analysis in an enterprise software model, for example, SaaS model. You could look at customer lifetime value of, say, something in a marketplace model as what does it cost to acquire that customer? And then how frequently do they actually purchase? What is the take rate associated with that? And try to get some comfort around that. And, importantly, what you are trying to build up are those unit economics as they stand today; if you are comfortable that those are generating the return that you would want to see. Are they defensible over a longer period of time? And so that is where you have to understand the competitive environment, you have to understand the cost to serve, you know, the cost to acquire, and some markets tend to be more fragmented and have lots of investable ideas, like enterprise software. And some categories, like consumer Internet, tend to consolidate more around larger platforms, just given the nature of two-sided markets.
McLuskey: So that comes to the IPO, how companies filed. You started your analysis on that company now that you know that they are coming to market. Do you insist on a meeting with the management during that roadshow?
Fish: So it depends. We always like to meet with management teams any time we get a chance just because whether it was three weeks ago or three years ago, the last time that we met with them, you always learn something incremental I feel like. So in a perfect scenario, we always meet with management ahead of the IPO and ahead of an allocation.
McLuskey: And what are you looking for?
Fish: It depends on how much history we have. So if it is a company that we have known for a long period of time, we have done diligence on before, we understand the competitive dynamics, it is a different conversation because we are already a level deeper than we might be on a company that we have never met before, maybe a subsector we are not quite as familiar with. And so we are really trying to educate ourselves on the value chain, the competitive dynamics. And those are meetings that a little more work, or more uncertainty coming out of them because we don’t have the history and we are trying to get comfortable with those. And so it depends on the history with the company.
McLuskey: Right, and what kind of red flags can sometimes be showing up, or what kind of mistakes do companies that are coming to market sometimes make on these roadshows?
Fish: Yeah, I think one of the most important things that we look for from management teams, I mean we are trying to assess the quality of management. I should have said that in your last question because it is one of the most important elements of doing an IPO roadshow and it is getting comfortable with the management team and that is why we like to have history before that. So this is a tough business for everybody and we all want to go around and talk about how great our company is and how we are going to conquer the world, but humility is a huge part of the process, too. And understanding what the real risks to the business are, not just what is laid out in the S1, but kind of the real like competitive dynamics and risks and industry structure and being open and honest with investors I think is really a key part of the process and is super helpful. Sometimes you have to strike a balance because you are eager, you are enthusiastic as a management team, you are about to go public, you want to talk about how great you are, but also being balanced in your assessment, as well, is helpful for us.
McLuskey: So sometimes after an initial pop when a stock first goes on sale, the excitement about the shiny new thing, I guess, they can sometimes struggle in the first year. I think a good example of that would have been Facebook, which declined 53% in its first four months on the market. But since then, in, I think, about five years, almost exactly since then, it has gone up more than five times. So stocks can often also fall around the time the lockup period ends, after about 180 days. So sometimes when you are assessing a company, do you think about that? Do you wonder, let’s wait and see what happens and then go in?
Fish: It depends. I mean what we are generally doing is we are defining what we think the company can be worth in five years based on all the information that we have available and how we model it out. And so stocks are going to come at a certain price, we have an idea what we think the stocks are going to be worth in five years, and a lot can happen between here and there. A lockup can put pressure on shares; a company could go through a transition, like Facebook, is a perfect example. The right reaction seemed to be at the time that Facebook stock should be down a fair amount. They had a unique situation where they were going through a business model transition right as they came to the public markets, where they were shifting from desktop to mobile and that put some unique pressures on the business in the short term. But if you modeled that out over a five-year period, you started to get very comfortable with what this business could look like five years down the road and that created an incredible opportunity for investors. By the way, it still created, investors have been heavily rewarded had they bought the first day, right. I can’t remember if the stock, how long it traded up or if it traded down the first day. But there was plenty of value to be created over a multiyear period if you got the business analysis right. And that is what is most important in any of these. Ultimately, the price of the asset three to five years down the road is going to reflect the financial performance of the company and not necessarily what lockup put pressure here or where investor expectations were two quarters out of the gate. That all takes care of itself over time. And so if you get that right, you can look through all the other noise and actually take advantage of it, if it presents itself.
McLuskey: Yeah, absolutely. I think if you bought Facebook at its $38 offer price, you might not have been happy come September of that year when it was $17, but you would be pretty happy now at $190, so yeah. That is definitely the case there. And looking at some other things, the Wall Street Journal the other day, citing data from Dealogic, reported that since 2016, about 50 U.S. business-to-business software companies have gone public compared with 13 consumer tech companies in the same timeframe. And the B2B companies have performed way better; their share is rising a median 126% through mid-April 2019, compared with a median 15% for the consumer-facing companies. Some of the reasons for that, and does that influence your preferences for business-to-business operations versus consumer-facing companies?
Fish: Well, we have invested in both, but we have invested aggressively against enterprise software and business-to-business companies as you talked about. And that has been a multiyear journey for investors to get to that point. And what has been important is if you rewind 10 years ago, there is a really lack of understanding around what the unit economics of the businesses were because they looked wildly unprofitable on the surface. So you really had to dissect these businesses and you had to see them develop and start to mature to get a feel for what these businesses could really earn as the growth started to slow down, how valuable they were. And then we also have gone through a sustained period where both strategic and financial buyers – and what I mean by that are the big tech companies – have actually gone out and bought a number of these companies that have come public. And then you have actually seen private equity financial buyers come in and buy these assets, as well, at really elevated multiples because everyone is doing the same work and getting comfort level with what churn is, what customer acquisition costs are relative to lifetime value to the customer, cohort analysis; there is a lot of data that management teams can provide to investors that can get them comfortable, that they have a license to go out and underearn and grow their business. And that is an area where that has clearly happened, it is clearly no secret in the market now, given where some of the valuations are, but that is what has happened.
Consumer Internet, it is hard, because there are some great investments, some great investment opportunities, but it doesn’t take much to change the fundamental competitive position of a consumer Internet, small- or mid-cap company. If Google or Amazon or Facebook changes their behavior and decides they want to attack their market, or Google changes its algorithm, suddenly a retargeting company can no longer retarget in the same way they could and they are not as effective. Or Facebook changes its APIs and suddenly a gaming company that relied on Facebook can no longer rely on them. And so there is a lot of power in the platforms. So it just makes it harder. The degree of difficulty in consumer Internet platforms is just generally harder because the range of outcomes for the businesses is just a lot wider.
McLuskey: And if those outcomes are wider, how does that influence your decision to invest? Does it mean you are going to take less risk?
Fish: Yeah, position size accordingly and more selective in terms of which ones we actually invest in.
McLuskey: That then brings me to, so you have decided you are going to go into an IPO. So how do you think about the size of your order? And how that investment will impact your overall portfolio, its construction, its balance, its risk profile?
Fish: Yeah, it is, frankly, if you look out at the IPO process today, you hope to be in, for the deals that you want to participate in, so we tend to be more selective, we don’t participate in everything. And, as a result, hopefully the allocation procedure is a bit more favorable when it is apparent that we want to be involved as long-term owners of assets. But one of the most difficult things, I think, for management teams, for bankers, for investors, is the IPO allocation process is usually pretty distributed. And so the allocation itself generally doesn’t get you anywhere close to the position size that you would want to own and then it is a question about how you build that position over time in addition to that allocation.
McLuskey: Right. So you are conservative out of necessity, it is not out of choice sometimes?
Fish: Yeah. Yeah, more times out of necessity than choice, yeah. We are enthusiastic about the growth opportunities and we size them accordingly in the Optionality portion of the portfolio. In an ideal world, we will own them and we will get more confidence in the range of outcomes of the business, we will get the right valuation, and under the right conditions, we can actually make a certain subset of those IPOs Resilient positions at some point in time.
McLuskey: Take a step back for me and explain to me, what is Resilience and what is Optionality?
Fish: Yeah, so the way we construct the portfolio, we generally have two buckets, almost as though two portfolios in one. Resilience side, you can think about it is about half of the portfolio are effectively businesses where we have a high degree of confidence in the range of outcomes for the business over a multiyear basis. We are very comfortable with the management teams, capital allocation, business model defensiveness and we have larger positions in those companies. Importantly, those are secular growth companies. Those not value companies, but the secular growth.
And then the other half of the portfolio, we actually invest in what we would call Optionality positions. These are companies that tend to be earlier in their life cycle, hence, where an IPO could potentially sit. They have a lot more potential upside, they also have more downside. You know, we are going to be wrong about them more. So as a result, we size them accordingly, and those are generally less than 1% in position size. And we assess them for two reasons: one is what should the, how is the business executing and should we actually be making it a more meaningful position, meaning ultimately graduating to a Resilient position? Or if we have been wrong, then should we be working that out of the portfolio? And that is an ongoing process.
McLuskey: Well, by the sounds of things, it is a pretty full plate that you have got for yourself just now and you have a heck of a lot of work to do to not only analyze the attractiveness of upcoming deals, but also to figure out how those newly public companies might impact the overall risk profile and balance, or as you put it, the Resilience and Optionality of your portfolio. So I would just like to finish by thanking you for taking the time to visit with us today and giving us such a valuable insight into just how you go about assessing each IPO opportunity. Thanks, Denny.
Fish: Great, well, you are welcome. Thank you.
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