An article co-authored by a renowned corporate finance and investment professional Dmitry Suschov, about initial public offering. IPO: Looking into the Future.
Over the past two years, almost all major Russian companies, with the exception of oil companies, have announced their intention to conduct an IPO. So far, the reality is much more modest: only 3-4 companies have managed to implement their plans. Nevertheless, we expect that over the next 3-4 years the number and volume of initial public offerings will increase. To conduct an IPO in 2 years, preparation for it must begin today.
The abbreviation IPO (initial public offering, or primary placement of shares on the open market) is becoming fashionable in Russia. Not as fashionable as in the USA in the late 1990s, but still frequently used. Almost all the most significant companies (except for those in the oil sector) have announced placement plans. Seminars on initial public offerings are held in Moscow every month. IPOs are the focus of websites and articles in glossy business magazines.
Everyone wants an IPO, but few have seen one. The Russian companies that have conducted a genuine initial public offering of shares on the open market can be counted on one’s fingers. Strictly speaking, over 8 years we have only managed to count 7 cases where the company was unequivocally Russian and the placement was unequivocally initial and public.
Who is to blame?
Several explanations can be offered for today’s relatively small volume of share placements by Russian companies.
First of all, most Russian and international funds investing in Russian shares “got burned” in the Russian crisis of 1998. This means that the risk of investing in Russian shares is perceived as high, and accordingly, expectations regarding returns remain high. Perhaps investors still expect an annual return on investment in Russian shares at an IPO level of 15-20%.
Meanwhile, the cost of debt capital for most reliable companies is consistently below 10% per annum in dollar terms, i.e., below the Russian consumer price inflation rate. Also, in a number of industries, owners of potential IPO candidates found strategic buyers and sold them part of the business or created joint ventures to attract funds. Even those companies that began preparing for an IPO quickly discovered that it was cheaper and easier to raise money in the financial market or to secure funds from a foreign strategic investor.
Over the past 5 years, the Russian economy has grown by approximately 175% in dollar terms, or an average of 23% per year. Moreover, 2/3 of this growth was driven by the revaluation of the ruble against the dollar and the increase in dollar prices for almost all commodities. For company owners, sharing the fruits of such hypergrowth with portfolio shareholders was indeed not very wise, especially in situations where sources of debt financing existed.
In addition to the placement commission (which in itself is quite high), companies placing shares on the open market must bear the costs of creating a high level of transparency and maintaining it after the IPO.
To place its shares on the market, a company may require restructuring and bringing it into compliance with the requirements of foreign legislation and investment funds. In this case, it is not only about the costs of lawyers and international audit, but also about the cost of management time, without whose participation restructuring and preparing the company for sale is impossible, as well as about the potential tax losses from consolidating all operations under a single Russian legal entity.
The company must also reorganize its internal control systems. Many executives are sensitive to potential “moral costs,” for example, those associated with the need to disclose the salary levels of the company’s management.
Legislative requirements for companies whose shares can be purchased by regulated investment funds of foreign countries have significantly tightened, especially in the USA. In the UK and continental Europe, such rules are somewhat more liberal, but here too there is a trend towards tightening.
Generally, the international market for new share issues is not at its best. In 2003, the number of issues dropped to 793 (the lowest level since 1990). The total value of IPOs also fell to its lowest level since 1993, amounting to just $53 billion.
Furthermore, international markets have not particularly noticed Russia and the CIS countries yet. The key region last year was Asia, and primarily China. Despite market instability due to the threat of atypical pneumonia, 2/3 of all IPOs came from this region, while in Europe and North America their number steadily declined. Asian companies attracted more than half of all capital – about $28 billion.
The industrial structure of the Russian economy plays a certain role. The most attractive for investors in Russia have traditionally been extraction companies and early-stage processing companies. At the same time, this sector accounts for only 12% of the global IPO market, and one can expect that the global portfolios of equity investment funds will allocate approximately the same share. In any case, due to high commodity prices, these companies are the least in need of new money.
As a result, most Russian companies still prefer other sources of raising capital: issuing Eurobonds or ruble bonds, bank and project financing, selling a strategic stake to competing companies or partners.
The IPO market will grow.
Interest in IPOs persists. It is likely that over the next 3-4 years, the number of companies wishing to conduct a placement in Russia and the CIS will increase.
Currently, we know of several companies that are ready to conduct an IPO or could be ready within 2-3 months and are only waiting for the right moment. We are talking about possible placements totaling over $1 billion. Two or three successful large placements and increased enthusiasm from both sellers and buyers could trigger a chain reaction.
Most companies are forced to change their structure one way or another, regardless of whether they plan an IPO or not. The new Russian tax reality is such that in most cases a non-criminal business can be transparent.
For many companies, the “right moment” has already arrived, although not all have realized it. In 2003, 6 companies placed their shares on foreign markets, raising $150 million for investments in CIS projects. According to data from early September 2004, the 4 placements known to us raised almost $300 million (this amount includes only placements on Russian exchanges and the London Stock Exchange; there may have been others).
Several objective reasons suggest that the trend of increasing IPO volumes will be long-term.
From the perspective of foreign fund expectations, the situation remains uncertain, and perhaps the expected return on equity investment will increase rather slowly. The cost of capital for shares of Russian companies is largely determined by the investment risk, which in turn depends on volatility – on how sharply and quickly shares can fall. Unfortunately, the experience of YUKOS demonstrated this: the share price fell almost 5 times over 11 months, due to circumstances largely beyond the control of investors and even the company’s management. Incidentally, we note that progress is evident compared to 1998, when during the worst 11 months, shares of all the largest Russian companies included in the RTS index (and not just YUKOS) fell in price by an average of more than 10 times.
As for debt and international financing, its cost may rise, including due to increasing yields on international debt instruments. The US refinancing rate will almost inevitably rise, and with it, likely, the yield on the 5-year benchmark series, which is key for Russian financing. As a result, even if IPOs do not become more attractive to Russian companies, the relative attractiveness of alternative sources may diminish.
Most companies are forced to change their structure one way or another, regardless of whether they plan an IPO or not. The new Russian tax reality is such that in most cases a non-criminal business can be transparent.
More and more companies are preparing financial statements according to international standards. The Russian government unequivocally states that large companies will need to transition to International Financial Reporting Standards in the coming years. For some companies, this requirement may become mandatory as early as next year, regardless of their plans to issue new shares.
The situation on international markets may improve. Increased activity in the IPO market in Q4 2003 and Q1 2004 points to a restoration of investor confidence. During this period, 639 IPOs were registered for a total of $53 billion, compared to 332 IPOs worth $23 billion in the previous 6 months.
The observed upturn cannot be compared with the peak of activity during the boom in Internet technology and telecommunications markets in the late 1990s, nevertheless, many financiers view the current trend (if it persists) as a return to normal after a period when most stock markets were closed to IPOs.
It may still be too early to speak confidently about a stable trend. However, if the current growth rate of IPOs continues, then 2004 could be compared to 1998, not the most successful year, marked by crises in Asia and the CIS, when the total value of approximately 1100 IPOs was $118 billion. Nevertheless, compared to the two previous years, achieving a similar level in 2004 would indeed signify a recovery of the IPO market.
Finally, owners of Russian and CIS companies may be more motivated to sell stakes in their companies. No one expects such dollar growth of companies over the next 5 years as was seen in 1999-2004. This is evidenced by the results of a survey of companies in the food industry and commodity sectors, as well as common sense, since oil and other commodity prices cannot rise indefinitely.
What is to be done?
Thus, an increase in the volume of share issues by companies in Russia and the CIS is highly probable. Preparation for an open share issue is perhaps the longest and most labor-intensive process in the stock and financial markets.
Several years ago, the company Ernst & Young together with Harvard University conducted a global study, surveying executives of over 2,500 companies that had conducted an IPO. The aim of the study was to identify key factors that determine the success of an initial public offering. Respondents were asked to assess the long-term results of the placement as very successful, successful, or unsuccessful. These and other responses given during the study were compared with actual performance data for each company (sales volume, profit indicators, and market capitalization) over the 3 years following the completion of the placement. As a result, it turned out that within 3 years after the IPO, the average value of very successful companies doubled; unsuccessful companies lost an average of 10% of their value at the time of placement over the same period.
The study showed that the main factor for success is the level of preparation. […] executives of almost half of the companies we surveyed (47%) believe they were poorly prepared for the IPO. The majority (over 60%) of executives reported insufficient preparation. At the same time, more than 1/3 of executives of companies whose IPO was very successful believe that the results would have been even better with a higher level of preparation.
Among the main components of preparation, the following factors were named […]:
- business plan,
- transactions,
- restructuring,
- analysis of alternatives,
- justification of the need for an IPO and choice of venue.
Regardless of the decision to conduct an IPO or seek other methods of financing, you will not succeed if you do not have a competent and detailed business plan. If you decide to place your shares, the business plan will be invaluable in conducting the advertising campaign. At the same time, the information needs of the target audience (potential investors) must be considered in light of your own information goals, what you want to convey to the target audience. A thoroughly prepared business plan will save you time and money in preparing the information memorandum and presentations for investors, significantly speeding up the IPO registration process.
When developing a business plan, it will become clear which areas of your company’s activity create value and which reduce it. Restructuring helps make the company more understandable for potential investors and the analysts whose opinions they heed. Successful restructuring will allow increasing funding for core areas by extracting capital from non-core ones, while simultaneously increasing the company’s value before conducting the IPO.
Furthermore, this is an opportunity to analyze options for development through investment in existing assets or through acquiring new ones. Several successful transactions during the preparation for an IPO can significantly improve its outcome. In addition to purchasing new assets, such a transaction could be a private placement of shares among a limited circle of investors. For example, during preparation for its IPO, the company Wimm-Bill-Dann attracted the Templeton fund through a private placement.
When preparing a business plan, one should clarify the goals of conducting the IPO and compare alternative ways to achieve these goals. An initial public offering is a complex and costly process, so it always makes sense to consider other methods of achieving the set objectives. There is no alternative to an IPO only when the goal is to create a liquid market for the company’s shares. Moreover, the very fact of conducting an IPO does not guarantee share liquidity; preparation also plays a major role here.
Share liquidity also depends on the choice of venue for the IPO. When comparing different stock exchanges, besides the placement location, one must also consider the cost factor associated with placement on a particular market. One-time and annual costs should form the basis for justifying the need for an IPO. This justification can take the form of a feasibility study, supplemented by an analysis of the non-financial advantages and disadvantages of a public offering in a specific case […].
Justification of the need for an IPO (public offering).
| Advantages | Disadvantages |
|
|
|
In lieu of a conclusion.
During the study […] executives of most entities whose IPO was successful stated that they began preparation 2 years before the start of the placement. To improve the level of preparation, many postponed the start of the placement, preceding it with other forms of financing. Even if you decide to cancel the IPO during preparation, the time spent on it will not be wasted, as a company that is ready for an IPO is ready for any other methods of financing. (Source: article ‘IPO: Looking into the Future‘. “Securities Market”, # 20 (275) / 2004).
A.Life 