Despite a grim first quarter for primary issuance in capital markets, the trickle is to be followed by a tsunami of big tech IPOs. The question is, which of them will sink and which will swim? Kat Van Hoof investigates what is driving the wave of tech unicorn IPOs.

Surfing big tech

The pipeline of tech unicorns (companies with valuations north of $1bn) and ‘decacorns’ (companies valued at $10bn and up) looking to hit a listing window in 2019 is massive. After years of huge private funding rounds, many of the so-called tech disruptors are expected to launch initial public offerings (IPOs). These listings are some of the most anticipated deals of the decade, but they are not without controversy.

Most of the tech disruptors have yet to turn a profit. Although revenues have grown at staggering rates, they have invariably been eaten up by swelling costs, raising questions about whether they can ever turn this trend around. Regulators have taken note. As governance has become an increasingly important factor for investors, the 'key man' risk – whereby the company's fortunes are intrinsically linked to a high-profile CEO – and propensity for ‘dual-class’ share set-ups are red flags for many investors.

More so than for any other type of IPO, big tech offers the chance to enter into the next $100bn-plus market cap tech giant at a very juicy discount. But in a sector where the divide between the nags and the thoroughbreds is at its widest, investors need to consider carefully which horse to bet on.

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“There has been a tendency to lump the tech disruptors together in a group, but this is very misleading. They have very individual profiles, capital needs and business models, so it is important to consider them company by company,” says James Gautrey, an international equities portfolio manager and tech specialist at Schroders.

Fear of missing out

Ride-hailing apps Lyft and Uber, social media platform Pinterest, home rental marketplace Airbnb, and work messaging board Slack. These apps have been a part of many people's daily routine for years and it has become difficult to imagine life without them. Despite their highly public profile, none of them were publicly listed as of early March 2019.

In a sense, these companies have been ‘semi-private’ for years. “They are already doing the majority of what listed companies do; they produce annual reports, their merger and acquisition [M&A] actions are highly scrutinised and their CEOs have star quality,” says Sebastian Lawrence, a banker on Investec’s telecommunications, media and technology team.

There has been much ado about valuations, both during private funding rounds and in the lead-up to an IPO. "The valuations for these businesses are pretty transparent, which is unusual, and they have been in the limelight for so long that people are very familiar with the brands,” says Tom Johnson, head of equity capital markets (ECM) for Europe, the Middle East and Africa at Barclays.

Lyft wrapped up its IPO in late March, raising more than $2bn, Pinterest had wrapped up bookbuilding in mid-April, while Uber and Slack have filed listing documents with the US Securities and Exchange Commission (SEC). But why are they all coming to market now?

“A lot of these names have been in the pipeline for a long time; these IPOs have been anticipated for a couple of years,” says Mark Hantho, chairman of global investment banking and global head of ECM at Deutsche Bank. After what have sometimes been record-breaking private funding rounds, many of the tech unicorns have reached a point in their lifecycle where an exit is the logical – or only – next step. "A huge amount of capital has been brought in from various investors at different times, so eventually they will want liquidity,” says Mr Johnson.

In the IPO market, it is not uncommon to see several similar companies come to the market at the same time. “There is a feeling of needing to get on the merry-go-round before the music stops. The fear of missing out can be a driver in this sense,” says Maegen Morrison, a corporate finance partner at Hogan Lovells, who specialises in ECM. Though if one such company performs badly in the aftermarket, it can cast a pall over other upcoming listings, she cautions.

Europe's slow going

Economic pressures in Europe have led to the worst start of the year for IPOs in a decade in 2019 and the government shutdown in the US stopped issuers from coming to market. Yet, if even half of the anticipated floats happen, 2019 could be a record year in terms of global volume.

IPOs are a lagging indicator of the wider economy, according to Mr Hantho, who says: “Pundits are predicting a slowdown, which has hampered ECM activity somewhat, but it hasn’t hit yet. Markets are still strong, so the wave of tech IPOs in this window is not so surprising in this context.” Mr Johnson agrees that economic forecasts are not ideal, but that the market is still good. The growth for the big tech companies is structural and therefore less reliant on macro conditions, he adds.

“We are 10 years into a bull market; the odds of a major correction occurring in the next few years are increasing materially. It makes sense to list now as the window may well shut in a year’s time,” says Mr Gautrey.

There will be cross-comparisons between some of the tech companies if they have converging business models. “If the comparison is not favourable, then there is still a very supportive M&A market, ready to scoop up businesses,” says Mr Hantho. Big tech has frequently used M&A as a way to ‘stay on top’ by buying competitors or bolting on new products developed by others.

Weather gauge

The first big tech company out of the gates with regards to an IPO was ride-hailing app Lyft, towards the end of the first quarter of 2019. Smaller than its direct competitor Uber and geographically restricted to North America, Lyft was keen to list first. Demand for shares went through the roof as soon as the bookbuild opened, allowing the syndicate to price the deal at $72 per share, well above the initial top range $68.

Aftermarket trading started well, with a nice pop on the first day, trading mostly 10% higher than the debut price. However, since the start of April the stock has mostly declined and now stands at $56.

The IPO market has been relatively fragile recently and if a few companies perform badly in the aftermarket, it can quickly put a damper on future listings, according to Mr Johnson. Uber has since filed for an IPO and is aiming to list in the second week of May. It is difficult to gauge at this stage whether Lyft’s less than stellar performance is helpful or a hindrance to Uber.

For IPOs in this sector at these high valuations to do well post-IPO, they tend to require sustained investment from institutional investors. Lower quality accounts typically sell as soon as the deal is printed, to cash in if it pops or to cut losses if it does not. “Speaking from experience, big institutional investors need to be prepared to pay 30% to 40% more on an already high IPO valuation in the aftermarket in order to fill their orders. So you need to be very convinced of the five- to 10-year prospects and real structural growth to do that,” says Mr Gautrey.

Many of the IPO candidates are maturing and getting into lower growth patterns, according to Mr Hantho. “Many of the IPOs will no doubt be successful, but the question is: realistically how much upside is there?” he asks. Other tech giants listed at an earlier stage in their lifecycle, such as Facebook, Amazon, Netflix, Apple and Google, so their growth curve has been long and steep.

Road to profitability

So long as interest rates remain low, investors are more likely to take a punt on a hot tech disruptor, given that it may well end the year over 50% higher than its IPO price. Big sell-offs in 2018, first in February and then again in December, have reined in some of the more fanciful valuations, but new tech shares still do not come cheap. With such a full pipeline, opportunity cost is higher than ever, so fund managers are having to be careful in who they back.

Valuations on big tech companies are incredibly attractive, partly driven by the scarcity of high-growth companies coming to market, according to Mr Hantho. However, investors are looking at business models with more scrutiny than ever before, especially if companies are unproven and not yet profitable, he admits.

Lyft was hit by questions about its ability to turn a profit post-listing, bringing down its market value. Pinterest put out a price range which valued it slightly below its last funding round, but managed to price the IPO just above the $12bn valuation. “When listed, there will be more pressure for these companies to have a clear path to profitability and to eventually self-fund growth,” says Ms Morrison.

Investec’s Mr Lawrence agrees that investors are increasingly concerned about future profitability, but argues that so long as the losses are incurred in the service of growth, they are less of an issue. “Losses can be, and have been, turned into profits with relative ease before, especially when revenues are still growing very fast,” he says.

"Investors are very pragmatic. They judge a company on its merits and tend to be tolerant if they understand the story and what the company is trying to achieve – it is all about the growth,” Mr Johnson concurs.

Where does the money go? 

Some unicorns may be closer to profitability than others. There has been a tendency to lump tech platforms together as if they all operate in the same way. In reality, they all operate in different sectors with different business models. As most of these businesses immediately reinvest most of their revenues after costs into marketing and sales efforts, margins are very important. And it turns out that not all unicorns are created equal.

“The underlying economics and business models are very different in terms of margins and supplier power,” says Mr Gautrey. Businesses such as Spotify and Apple Music come in at the bottom end of the margin ladder, as they rely on just three music suppliers that can tightly control pricing. Companies such as Uber come in the middle of the pack as they have relatively high costs and headcount, while the highest margins are to be found at the Appstore, because of Apple’s ties to the iPhone, and Airbnb, which works with more than 3 million hosts and can set its own pricing.

The nature of cost bases also differs wildly among tech disruptors. Lyft has been subsidising rides for all of its seven-year existence, making investors question the sustainability of this practice. Uber has struggled with the same sort of questions, as well as the rising cost of drivers, who have pushed for more workers’ rights. In the gig economy, the line between flexibility of employment and exploitation can be wafer-thin.

Regulators have been alarmed by the astronomical growth of the tech unicorns and the speed at which they are changing the landscape. In the wake of the recent terror attack in New Zealand, where footage of the massacre was live-streamed on Facebook and shared on YouTube, there have been calls for more regulation. The weight of regulatory pressure is so enormous that both Facebook and Google have hired tens of thousands of staff to manage and curate content, according to Mr Gautrey, who asks: “How can a smaller company possibly afford that and stay on top of regulations?”

Uber and Airbnb have both fallen foul of local regulators, banning them from operating in certain regions, and regulators have turned their attention towards online marketplace monopolies, including platform goliath Amazon. Investors are concerned that regulators could take steps that would hamper future growth.

Disruptors disrupted

A lot of capital is also being thrown at the development of new products, which can be hit or miss. Uber, Lyft, Airbnb and WeWork have often been referred to as ‘disruptive tech’, because they undercut traditional players in their respective sectors. 

“Switching costs for customers are really low, so it often comes down to which interface is more swish to sway customers,” says Mr Gautrey. And there is always fresh venture capital available for the next disruptor. There is nothing to stop another disruptor from coming in and doing the same thing, according to Ms Morrison.

Some of the ‘old guard’ are using the disruptors’ tactics to make a comeback. For instance, London black cabs have a ride hailing app of their own. “Uber makes slim margins on its rides. If it needs to raise prices, then the main difference with traditional black cabs is that Uber can’t move through traffic as fast,” says Ms Morrison.

Uber’s foray into self-driving cars has also been questioned by the investor community. It is hugely capital intensive and success is by no means guaranteed. It would be a huge win, however, if Uber could beat competitors to using driverless vehicles as it would eliminate its biggest cost: the drivers. However, as a recent fatal accident with a test-driver shows, important questions about who is liable for accidents and how to account for this risk are still to be answered.

The market has not yet forgotten the debacle around social media company Snap in March 2017. It listed at $17 per share, above its initial range, but plunged to as low as $5 in late 2018. The stock rallied by more than 100% this year, but is still hovering at 30% of its IPO price. Snap fell apart almost as soon as it listed, one banker says, adding that the market fundamentally underestimated how thoroughly Instagram’s stories feature would undercut Snap’s customer base from the start.

Smaller social media companies suffer from a lack of scope compared with a big player such as Facebook. “Twitter and Snap both cornered quite a niche audience, without expanding or growing their user bases much,” says Mr Gautrey. Pinterest has sown-up the US stay-at-home mum market, but in order for it to continue growing, it will need to appeal to other audiences, he adds.

Even Facebook’s top dog position is not guaranteed. The company has been hit by back-to-back scandals and privacy issues, from its Cambridge Analytica data revelation to a huge data breach that saw hackers obtain the personal information of 50 million users. Usage in Europe and the US dipped briefly, and though it has again picked up, questions remain about Facebook's long-term attraction, especially for younger generations who may not want to share a platform with parents and grandparents.

Key man risk

Not long ago, Uber was Silicon Valley’s biggest problem child. In 2017, co-founder and CEO at the time Travis Kalanick, known for his abrasive leadership style, was caught up in a storm of negative press over his bad behaviour. The company was accused of inaction on sexual harassment allegations, and of fostering a toxic macho culture. It was slapped with a fraud lawsuit by one of its early investors. Mr Kalanick stepped down in favour of Dara Khosrowshahi, formerly CEO at Expedia, who has steered the company into a more mature stage.

Uber is not the only big tech company that has been beleaguered on account of its CEO: Mark Zuckerberg at Facebook was called in front of the US Congress to testify on the topic of the right to privacy in the wake of the Cambridge Analytica scandal and several tweets have landed Tesla’s 'top man', Elon Musk, in hot water with the SEC. In an age of engaged and aggressive activist investors, governance is top of the list of investor concerns.

“The cult around CEOs of start-ups is important for attracting private equity and venture capital funds, but they may not always have the most suitable personality type for a large listed company,” says Ms Morrison.

Should investors pay a premium for the visionary entrepreneur at the helm or should they get a discount to account for the key man risk? “Investors understand that a big reason the unicorns are famous is the brains behind them,” says Mr Lawrence.

Mr Gautrey argues there needs to be a balance, which can be achieved by having a good bench of people behind the CEO. Key man risk is often overplayed in his opinion: Apple did not fall apart after the death of Steve Jobs, as he had a circle of strong people at the top to take over. Many tech companies have independent directors in place to prove good governance, Mr Hantho agrees.

Dual-class struggle

Key man risk is more of a factor when companies decide to list with a dual-class share structure, whereby the class of shares sold in an IPO typically carry fewer voting rights, allowing entrepreneurs to retain an iron grip on control. Lyft employed this tactic in its recent listing, as did more established tech companies Facebook, Google and Alibaba.

Tellingly, Uber has opted not to use dual-class shares in its IPO filing. The company has been eager to show it has shrugged off the worst excesses some tech unicorns have been accused of. Rather than battling every competitor for market share in different geographies, current CEO Mr Khosrowshahi decided to acquire the market leader in the Middle East, Careem, for example.

While unloved and uncommon in Europe – the London Stock Exchange has refused to even consider introducing weighted voting rights – the practice is much more accepted among US investors. Yet even across the Atlantic investors have pushed back on dual-class share structures, according to Mr Hantho. “Not enough to make it difficult for tech companies to list at the valuation they have been targeting,” he adds: “If it is a good investment, then investors will accept it.”

“This structure appeals to entrepreneurs as a tool for taking the company from private to public and managing that transition. In many cases, I don’t think the founders necessarily see it as a permanent measure,” says Mr Johnson.

This may be wishful thinking, according to Mr Gautrey. However, he says: “It is a risk I am willing to take, if I trust the people in charge.” It can be an advantageous set-up. He points to Google, which made two acquisitions in 2006 of little-known loss-making companies, paying a combined $1.7bn. “Without the dual-class share structure in place, shareholders would have almost certainly voted both deals down,” he says.

The acquisitions in question? YouTube and Android. “Without these fabulous decisions, Google would only be half the company it is today,” he concludes. 

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