The worst year for IPOs in two decades, but a great opportunity for investors

Glenn Freeman

Livewire Markets

Investing in early-stage listed companies – or better yet, those eyeing an ASX listing – only to see earnings (and share prices) skyrocket inside a few short years is the dream of many Aussie investors.

But this year, you probably would’ve been disappointed. Outside of the micro-cap space, there’s been only one IPO of a company that's raised more than $70 million in 2022 so far. This is just a fraction of the 2021 figure, year-on-year, as shown in the chart below.

Figures current as of 30 June 2022. Source: Yarra Capital, Bloomberg.

In the current market environment, global IPO activity is effectively closed, with US companies raising less than US$5 billion in capital in the first half of this year, according to data from EY and Dealogic. The full-year figure will fall well short of the barnstorming US$155 billion figure of 2021. Last year, there were 1035 IPOs, an all-time US record.

But therein lies the opportunity, says Yarra Capital Management portfolio manager David Acton.

“It’s in these environments that businesses needing to raise capital are more flexible in how they do that,” he says, speaking with Livewire on the back of a recent webinar.
“We think the longer the IPO market is closed, the more prospective opportunities will emerge for patient, late-stage equity investors.”

“We know IPO markets are volatile…clearly 2021 was a good year for IPO volumes, but this year will probably have been the worst in about 22 years,” says Acton.

“From what we can see, it’ll stay that way for at least the first half of next year and potentially longer. But at some point, the IPO market will reopen, and history suggests we’ll see a strong rebound in IPO activity which could last for multiple years.”

What is pre-IPO investing?

The pre-IPO market exists to provide capital to unlisted companies. Typically referring to companies in their final round of private fundraising before ringing the bell at their local stock market, this round usually occurs between six and 18 months ahead of the IPO itself. The Yarra fund invests in established and proven businesses up to three years out from either IPO or trade sale. The flexibility on timelines to exit is resonating with the firm’s clients, Acton says.

It’s also worth mentioning the distinction between this Alternative asset class and another that’s been top of mind more recently – private equity.

As Acton explains, PE usually requires more control of the underlying asset and usually also involves applying at least some financial leverage. Typically, the Yarra fund will only hold between 5% and 10% equity in any one company.

“We come in as patient and minority investors, and we don’t apply financial leverage to our investments. And although people typically describe our segment as pre-IPO, we consider ourselves late-stage growth investors,” he says.

“We do like to engage and support, and look for businesses that want this, especially regarding their capital markets activities, but we’re not there to interact day-to-day with the operational aspects of the business.”

The Yarra Private Capital Discovery Fund’s investment timeline will be five years. After the fund’s launch, at the start of December, the first three years will see Acton and his team focused on investment activity, after which they will begin progressively exiting investments via IPO or trade sale and returning capital to investors.

Why now?

Acton and the Yarra team believe now is the right time for pre-IPO investing, largely because of the current malaise that afflicts economies and IPO markets. He points out that valuations across some segments of the market, including within the tech sector, are down between 50% and 80%.

“As with any investing, your entry valuation determines your returns, and we believe that investing now – when valuations have retraced significantly over the last 12 months and more – will provide the best outcome,” says Acton.

“There’s a lot of fear. And history shows time and time again, when there’s a lot of fear is when the best investments are made.”

They also expect their earlier investment in companies eyeing an ASX listing – rather than the typical six-to-12-month pre-IPO rush – will help deliver the fund’s ambitious return target of 15% p.a. net of all fees (which is around double the long-term return of the ASX).

Another couple of reasons he believes the timing is right include:

  • Inefficiencies in the segment – with a handful of competitors that are in many cases fully invested, meaning capital is scarce.
  • Favourable terms on the table from firms looking to IPO.

“The most important reason for incoming investors is the substantial improvement in terms – the risks and rewards you get for investing – than was available 12 months ago,” Acton says.

Back then, there was scant room for investors to negotiate because the market was flush with capital. Companies now have to work harder to generate capital and are offering preferred terms via deal structures that are now more favourable to incoming investors.

“There’s very little capital raised relative to each of the last five years, and we expect this to continue into 2023,” Acton says.

Where are the opportunities?

Industrials and Commodities are among the biggest areas of focus for the Yarra team currently. Acton suggests these sectors will comprise more than 50% of the portfolio when the fund launches. Looking particularly at metals and mining companies, the push toward decarbonisation and electrification is a core theme.

Technology will also feature strongly, with a mandated limit of 50%, though Acton says this total allocation will likely be far lower.

Key themes the team is eyeing are:

  • Essential services and infrastructure manufacturing
  • Healthcare and medical services
  • Leisure and entertainment, such as gaming and streaming, travel, telecommunications, and
  • Technology and innovation – including healthtech, medtech, and agtech.

Finding pre-IPO opportunities

Yarra is targeting a $100 million plus raise and closes the fund at the end of November. The final portfolio will comprise between 10 and 20 Australian companies, typically between $100 million and $400 million in equity value.

Acton says he and the team are already meeting with target companies, and he expects to see around 300 opportunities each year across the fund’s investment period. This list will then be whittled to a shortlist of between 50 and 70 names in the second stage before ultimately settling on 10-20 investments.

“We look for businesses that have the usual strong characteristics that make investors feel comfortable,” Acton says.

From a business model perspective, this includes analysis of what’s driving revenues, customer bases, and any potential network effects or other attributes that help weld users to the companies.

Yarra will also weigh the competitive landscape for potential companies, their ability to maintain an earnings trajectory that exceeds their cost of capital, and any regulatory supports or risks.

“Internally, we also look at the quality of management and the governance, to help ensure we’re supporting people with the right priorities and values, with ESG a central element,” Acton says.

There’s no firm requirement for companies to be already generating a profit.
“We want proven businesses with track records. They don’t need to be making money, but we need to understand exactly where the operating cash flow is being spent, where they’re investing their capital and the company’s path to profitability,” Acton says.

“And we ensure the valuation is appropriate for the valuation they’re looking to achieve through the IPO or trade sale.”

The two key aspects here are that the valuation must be reasonable in both absolute terms and relative to the entry price they anticipate the company can achieve upon exit.

Want more info?

Click the following link if you want more information about the Yarra Private Capital Discovery Fund.

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Glenn Freeman
Content Editor
Livewire Markets

Glenn Freeman is a content editor at Livewire Markets. He has around 10 years’ experience in financial services writing and editing, most recently with Morningstar Australia. Glenn’s journalistic experience also spans broader areas of business...

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