IPO comeback: Is the drought over?

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Following weak IPO volumes in 2023, the pipeline of potential deals continues to expand. However, private companies looking to go public in 2024 may face tough hurdles, higher expectations from investors, and uncertainty leading up to the U.S. election in November. On this episode of Market Points, Scotiabank’s Global Head of Equity Capital Markets, Michelle Khalili, sits down with John Cronin, Head of U.S. Equity Capital Markets, and Matt Sheehan, Head of Canadian Equity Capital Markets. They consider risks and opportunities for first movers that are ready to test market conditions.

Michelle Khalili: Hi, John. Hi, Matt. How are you?

Matt Sheehan: Wonderful, Michelle. Thanks very much for having us.

John Cronin: Doing great. Good to be here.

MK: Today's discussion is going to be about the major themes on our radar for 2024. First, let's take a look back. In 2023, investors focused on the impact of rate increases by the U.S. Fed, as well as other major central banks. Most weren’t expecting robust gains in North American equity markets. So what happened and what drove market performance? John, let’s start with you.

JC: Sure. Thanks, Michelle.

Yeah. You know, it was a bit surprising, right? We had four rate increases throughout '23 and yet we saw some pretty strong performance in the markets in particular for tech. And the NASDAQ was up 43% versus the S&P at 24% and the Dow at 14%. So clearly the Nasdaq being tech heavy was a main driver.

But when we look at that, a lot of that was the magnificent seven. They were making up a large percentage of that, and those seven names were up roughly 75%. But despite the overall market gains, there were some sectors that underperformed as well. If you looked at utilities, energy and consumer staples, they were down 10, 5, and 2% respectively.

So those should be sectors that have some room to run as we look out to 2024. Matt, what did you see in Canada?

MS: Thanks, John. Canada is a bit of a unique market versus the U.S. Our sector weightings are very different. So we had another strong year in tech in 2023, much like our U.S. peers, that sector was up over 60%, almost 70%, but it only makes up about 9% of the broader TSX. So when we look and we dig down, it was really tech did well, we did have double digit gains in healthcare, industrial, so the breadth of the market, it did improve in right at the end of the year, but the same sectors at the bottom end of that totem pole, if you will, you had some of the interest sensitive groups like REITs, Utilities, Communications is a big sector in Canada, and the telcos suffered a bit, again, the interest sensitive sectors were lagging behind.

MK: Thanks for the recap. Certainly sounds like a case of have and have nots in both sectors. Now equity issuance, Matt, tell us the story about equity issuance in Canada in the past year.

MS: It was another tepid year in Canada and for equity issuance, it was about just over $18 billion dollars raised in 2023.

That was down substantially, call it 40 plus percent from a five-year average and almost flat-ish on a year-over-year basis. A lot of the themes that we talked about above in terms of interest rates becoming higher and the impact on cost to equity, it did impact people’s willingness to come to market.

That being said, what we did see and what really made up the majority of that $18 billion was some very large M&A transactions and associated equity. So, discrete M&A transactions in Canada made up almost 60% of the equity issuance in 2023. That’s well beyond what we would see over the last decade, which would be somewhere closer to 15-20%.

So that was the big theme in Canadian equity issuance this year, Michelle.

JC: I’ll just chime in from the U.S. side. When you look at the U.S. markets, we did see a significant rebound over 2022. 2022 was really a historically low year from an overall issuance standpoint. Having said that it was, three was still well below the historical long-term averages.

So, we did see a good increase. It was driven primarily by converts and follow-ons. We saw a little bit of IPO activity, but I wouldn't say it was anything meaningful. A few large transactions, but not a significant number of transactions, and they were mostly in the tech and consumer space. And SPACs remained quiet after huge years in ‘20 and ‘21.

On the follow-on side, primary issuance was pretty limited, primarily due to valuations, lower M&A activity, and companies focusing more on free cashflow. However, we did see some secondary deals with selling shareholders taking advantage of open windows throughout the year. So eight of the ten largest deals were secondary transactions.

The convert side was probably the most active when you look at it from a historic basis. Issuance picked up meaningfully driven by higher rates and the attractiveness of convertible coupons relative to those with straight debt. As a result, not only did we see non-investment grade issuers, but we also saw a larger percentage of investment grade issuers accessing the convert market.

I think it was roughly 30% that made up the convertible market. So, with rates remaining elevated, we think that converts will continue to be mainstream and that convert issuance will be pretty active in 2024 as we see M&A activity pick up and companies look to address upcoming maturities.

MS: Just to follow on with what John was saying on converts, I think it’s an important theme, it was a theme in Canada as well, it’s a smaller overall number when we think about how it moves the needle and overall issuance. But it was up almost 40% for the same reasons that John saw in the U.S., right, it’s a very competitive cost of capital versus straight debt and equity right now, something that impacted 2023 and should impact 2024 as well.

MK: Thanks John and Matt. John mentioned IPOs. John, if you can talk a little bit about what are those trends that we saw in 2023?

JC: Sure. Yeah, it was an interesting year, right? It was much lower volume than what we’ve seen historically, but there were some trends for sure.

One of the things that is worth highlighting would be the subsidiary or carve out IPOs that occurred, some very notable, sizable names such as Kenvue, Nextracker, and GE HealthCare. A lot of companies were looking to monetize and take advantage of their high growth subsidiaries to unlock value, and so we saw that for sure.

I think the other thing that was definitely very prominent in the market was the presence of large cornerstone investors in transactions. These investors obviously were there to not only bolster the quality of the order book, but also create demand tension. And in that respect, I think it worked well. I think one thing that you did see, however, was you saw smaller trading floats in the aftermarket as a result, and so that obviously can come with some challenges associated with it. But overall, you know, the other thing that we would say is that consumer facing brands were also front and center. We saw names that had a lot of both brand awareness and investor familiarity coming to market and in a lighter market where the dynamics are more challenging, that is something that you would expect to see.

Those would be the trends that I would highlight. Matt, what was going on in Canada from an IPO standpoint?

MS: Unfortunately not much, John. In 2023, there was kind of one IPO of note of over $150 million, which was Lithium Royalty Corp., so congratulations for them for getting that over the line in what was a tough market.

All the themes in terms of the challenges for IPOs are the same here, but it was a very muted activity for IPOs in Canada. We expect that to change in ‘24 and we’ll get into it a little later in this discussion.

MK: And certainly, we saw valuations start to recover, and that was a change as we went into the back half of the year, and certainly that could be a large driver of issuance in 2024.

Matt, can you tell us a bit more about that?

MS: Yes, thank you, Michelle. I don’t want to oversimplify things in a very complex market, but in short, as valuations increase and private companies and public companies are looking at different costs of capital, the more that the valuation is attractive in public markets, the more likely we’re going to see IPOs and follow on issuance, it’s pretty simple.

So when we look at valuations overall in the U.S., we’re already back up above average. So if you look at the S&P 500, its PE at the end of the year was almost 18 times, so that was up more than half a turn from 2022. It’s still below the levels in 2021 where we saw PE got up to kind of 21 times, but well above the 10 year average of 16 and a half.

In Canada, we've been slower to recover. Part of that is the sector weights that we talked about before, so we don’t have the tech weight that we do in the U.S. But that being said, the premium in the U.S. versus Canada is almost in every sector. If we look at the composite overall, Trading at just under 13 times at the end of the year, kind of 12.8., that’s again, that's up slightly from 2022, but still well below 2021 at 15 times or 15 and a half times, and the 10 year average of almost 15 times as well. So the Canadian market has some room to run. I think it's necessary before we start to see broad based equity issuance, but valuations have recovered from where they have been before or where they have been over the last couple of years.

We're not quite there yet in Canada, but not much more to go.

MK: And John, what bodes well for overall ECM activity?

JC: Well, I think a clearer economic picture is certainly gonna help. So better understanding where the Fed is going from a rate perspective. I think investors are going to be focusing on that very closely, and that will translate into issuance activity and how issuers look at the market.

I think with rate cut expectations in the market and some debate about when those are coming, generally speaking, that should be a catalyst for valuations, and that should help activity as well. I think the other thing that will help drive activity is going to be M&A, and we haven’t seen historically in ‘23 much M&A activity, but as we look to ‘24, we’re already seeing some green shoots there and some activity picking up, and as we do that should drive issuance into the equity capital markets and the convertible capital markets to finance the transaction. So those, I think, would be the main drivers and certainly anybody that’s coming with a good defined use of proceeds and a catalyst for the stock should be received well from an issuance standpoint.

MK: Thanks, John. Now looking at balance sheets, certainly the financial strain of higher interest rates over the past year has increased the need for equity capital for many corporate clients. Add that to depressed equity issuance over the last one to two years, and certainly it can result in a potential recovery of equity issuance in 2024.

Matt, what are your thoughts on that?

MS: It’s an interesting aspect to what we expect for 2024. As most people know, equity capital markets kind of does well on either side of the barbell when valuations get really, really high and the market's going well, people come to market the other end of the barbell where the market's really struggling, usually coincides with economic struggles and sometimes distress.

So I want to be specific. There’s not distress overall in the market. What we have seen is we have seen balance sheets overall, and it is sector specific. You have seen balance sheets expand. Part of that’s just the access to capital, but a lot of it’s just the cost of capital, and we have seen people try to take on less debt, given that increased cost.

That impacts certain balance sheets in certain sectors more. You’ve seen sectors like Utilities, REITs, Mining, where your CapEx is maybe a little less discretionary. You have seen balance sheets expand in those sectors. Again, I emphasize there’s no distress, but as you look for a recovery in the cost of equity capital, I think it’s fair to assume that those sectors could use equity capital to get back to growth as we move forward.

MK: So no distress, but given the cost of debt, use of proceeds are being used to pay down that debt. So, John, what are you seeing when it comes to leverage?

JC: Well, I think certainly when balance sheets are larger and leverage is a bit higher, and yet you have CapEx that may be non-discretionary or growth oriented, you’re going to need to use external sources of capital, not just fund internally or add leverage to the balance sheet.

So, we expect that as we see M&A activity pick up, as we see companies potentially fund some non-discretionary items, that they’re going to be accessing external sources of capital, in particular on the equity side, and probably also on the convertible side as it pertains to M&A. So, I think the ability to fund internally goes down, and the need to fund externally goes up.

MK: So there have been a drought of IPOs in 2022, and we’ve had a limited issuance in 2023, and so that’s led to what we have now, a healthy backlog of private companies, and some are watching and waiting for that window to open up to tap into the public markets. Over the last one to two years, many of those private companies have improved their financial profile, and as they're waiting for market stability, they’re looking at those windows. So, what are those factors that could support a successful IPO season, Matt?

MS: I think a point that we need to make here is that as much as issuance has been tepid over the last couple of years, it’s really been a supply issue, not a demand issue.

And I think it’s important because it does bode well for 2024, and what I mean by that is it’s really been a lack of supply. So the cost of capital has not been adequate enough for companies and issuers to use the cost of equity to grow, pay down debt, all the other uses of proceeds. We’ve seen lots of evidence of the ones that have found those appropriate uses of proceeds, and when they have, investors have been there.

You can look back to Enbridge, which was the single biggest equity transaction in Canadian history, which was multiple times oversubscribed. Other big, marquee, over billion dollar transactions this year. Investors are there. You find the right uses of proceeds. You can show growth, Canadian, Global, U.S. investors, they showed up. I think that’s important to note and something important to focus on as we move forward into 2024. Ideally, valuations get a little bit better. More use of proceeds come up for companies. Issuance recovers, but we do feel that investors are there. So when we look at IPOs and really when we see an opening of the IPO market, we have seen a bit on the south side of the border, but in Canada, it'll be led by quality.

You’re going to need businesses of size, of quality, of predictability. These are the characteristics that we really need to have the IPOs that come out of the gate. If anything, when I talk to investors and we look back at the boom, IPO boom of 2021, there were some great companies, some have done well, others have struggled.

A common theme from investors is liquidity. I think that’s one thing that investors are really going to look for. They’re looking for bigger companies. So if things don’t go the way they expected that there isn’t situations where companies become orphaned, I think liquidity is going to be paramount quality companies, quality management teams, but I’m really looking for sizable companies with growth stories.

Investors have the ability to go out and buy companies in the Canadian market relatively cheap today. So we need to focus on companies, and they’re going to have to offer something unique, and growth in the Canadian market is still, is still unique given some of our sector weights.

MK: John, what are you seeing in the U.S.?

JC: Yeah, I mean, many of the same themes for sure. I think the pipeline is building. I think companies looking to go public in ‘24 will be held to a higher standard. And the market will be looking for greater visibility in their business models, greater visibility on potentially profitability, and companies will be doing an analysis of whether they want to be the first mover into the market or whether they want to wait to see more data points.

So there will be a lot of things to think about as you look ahead to potentially going public. And companies will need to navigate a number of things, not only staleness states and overall market holidays, but also the U.S. presidential election, which will be happening later in the year. So we do think that companies will be taking advantage of testing the waters as they have previously, but probably doing it even more so to make sure that they’ve got a good sense for how investors think about their stories and what their opportunities are and what their windows are, so that will be a important piece of the reopening of the market. In terms of valuation and liquidity, as we look into 2024 with the uplift in valuation, we think issuers are going to be looking much more closely at accessing the market, both IPOs and follow-ons. I think certainly from a follow-on issuers perspective, with valuations having recovered and moving in the right direction, it makes it a lot more palatable to go out and raise primary equity, to fund CapEx, to fund acquisitions and, and other primary uses. And from an IPO standpoint, it certainly is a lot more attractive both for the issuers as well as their stakeholders, that being private equity or venture capital firms. So, we think valuation will be a driver for more activity, and we also think valuation will be a driver for more M&A activity with valuations up, companies are a bit more willing to pull the trigger on a sale, and with valuations up, companies that are a potential acquirer are more comfortable using their stock as currency. So, we would expect that M&A activity will pick up as well, which will also drive issuance.

MS: One element that I think we should touch on here with IPOs as well as the current private equity environment, I think private equity fundraising is becoming incrementally difficult, it’s probably just a point in time, it's not something we expect to last for years. But private equity companies are focused on monetizations. You’re seeing it in some of the secondary sell downs that John talked about earlier. There’s been a couple in Canada. But when we talk about monetizations, if you’re not selling businesses to other private equity, IPO is a valid option.

So I think as we look forward into 2024, those businesses have to have the characteristics that we’ve all spoken about, but I wouldn't be surprised to see private equity look to the IPO market for this monetization trend.

JC: No question. I would agree. I think that it’s certainly a viable option for private equity, and I think just given where we are in portfolios, that will be something that private equity investors will be looking at. One thing to note on the U.S. side, we are making significant investments into our overall U.S. business, with particular emphasis on the Tech, Healthcare, and Energy Transition sectors, which will continue to complement some of our existing and very strong sectors, that being Real Estate, Utilities and Energy, and we certainly are also very active on the Consumer and Industrial space. So, we think that our growth in the U.S. is going to continue and be robust, and we’re excited about continuing to serve our clients in the U.S. and abroad. Another thing to mention is that we do have a robust equity private placement effort led by Charles Kerecz. This will be key as companies will look to do incremental private rounds or companies that need a little additional capital before going public in ‘24 and ‘25 will look to raise that capital to be ready, so we think it’ll be an important way for us to help support our clients.

MK: Matt, John, great discussion. Thanks very much for joining us.

JC: Thank you. Appreciate it.

MS: Thanks for having me, Michelle.

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