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Floating on air

Is the upsurge in flotations by private equity-backed players based on solid ground, asks Scottish Equity Partners, or will the next round of European companies preparing for IPO find themselves floating on air?

Like weather forecasters, financial experts attempting to predict stock market sentiment are often caught out by unexpected storms. The hardest part is anticipating the winds of change.

Now, after a near three-year drought in the initial public offering (IPO) market, an upturn in activity has prompted fresh speculation on whether an encouraging flow of IPOs could turn into a flood and what it augurs for the venture capital market.

IPO statistics paint an encouraging picture. In the first half of 2004 there were seven trading company IPOs in the UK, compared to only two in the first half of 2003, according to KPMG. There has been an even stronger comeback on the Alternative Investment Market (AIM) where in the first five months of 2004 there have been more than 76 listings, compared to just 66 in all of 2003.

The picture is equally upbeat in the United States where 29 venture-backed companies raised $2.1 billion through IPOs in the second quarter of 2004. This was the highest number of IPOs since the third quarter of 2000 when 87 venture-backed companies went public (just before the dotcom market collapse), according to Thomson Venture Economics and the National Venture Capital Association.

However, according to Tom Attenborough, a Director in Citigroup’s Equity Capital Markets division, while there are grounds for optimism, it should be of the cautious variety.

“The European IPO market is definitely open but becoming selective,” he said. “It is however still a challenging environment. The opportunities for successful flotation are there - providing companies meet the right criteria. The majority of companies that are doing well are well established, large and already market leaders. In current markets, investors are interested in quality management teams, profitable businesses with defendable market positions, while there is no appetite for ‘hope value’ tech stocks that we have seen float previously.

“There has typically been very little middle ground with the IPO market,” he continued, “It’s generally either full steam ahead or completely closed down. But now we are finding ourselves in a rare period where the balance of top down concerns such as the oil price and rising interest rates and a positive bottom-up picture of strong corporate performance has created a more unpredictable scenario.

“Companies seeking to IPO have to be ready to take advantage of the right window when it appears as it may not be open for long, as we saw in the first quarter of this year. Companies like CSR that floated then were very well received. There was significant demand and offerings were heavily oversubscribed. Then, as we moved into Q2, the risk appetite declined markedly. Deals since then have been subscribed, but not heavily, and most offerings have priced towards the bottom of the range, or even below. Investors are currently only looking at high quality transactions where the valuation looks reasonable.”

Scottish Equity Partners (SEP) has the distinction of the being the only venture capital investor to have been involved in the UK’s two most successful technology flotations of the last year - Bluetooth specialist Cambridge Silicon Radio (CSR) which made its debut in February and Edinburgh-based fabless semiconductor company Wolfson Microelectronics which floated in October.

Yet despite the strong performance of SEP’s IPO companies, Managing Director Calum Paterson also urges caution: “The market for IPOs has definitely reopened but it’s a far from stable scene and the quality threshold is high,” he said.

“Wolfson and CSR share critical strengths, including first class management, credible track records in achieving key milestones, and the potential to achieve further significant growth as a public company. Any company looking to achieve a lucrative exit through an IPO in the current marketplace must be able to prove the same kind of star quality.”

As a result of the prolonged global stock market slump in the wake of the dotcom collapse, the relative maturity of venture capital backed companies going public has increased. This is partly because many companies have had to bide their time while the markets were closed, and partly because investors are indeed looking more closely at track records.

In Paterson’s opinion, this is a good thing. “It means that we won’t have companies going for IPO who aren’t ready for it,” he said. “Publicly listed companies are vulnerable to turbulent market changes and companies are much better geared to withstand these if they have a solid track record and have achieved profitability.”

“We prefer to see a business demonstrate its staying power before it takes the IPO route. We know that we need to give companies time to commercialise their technology and make real inroads into their markets. By giving them time to achieve scale and growth we believe more significant value can be generated.”

Wolfson Microelectronics is a classic example of a company with a track record that was well established before its IPO. The SEP team first invested in Wolfson in 1993 when it was a university spinout. By the time the company floated in 2003, achieving an initial market cap of approximately £214 million, Wolfson had over 150 employees, a global blue chip customer base and a turnover of over $70 million.

On the other hand, clearly some companies move more quickly than others from venture capital funding to IPO, as was the case with CSR, which was set up in 1999 and floated in March this year with a market cap at launch of £240 million. However, even in that short space of time, CSR had achieved a solid market-leading position and built revenues of over $100 million for its single chip wireless solutions.

For both Wolfson and CSR, the decision to take the IPO route has been vindicated after strong post-IPO performances, however Paterson argues that an IPO exit route is by no means the most likely or even the most desirable outcome for all high-growth companies.

“We’ll continue to see M&A as the more likely ultimate realisation route for the vast majority of the investments we make,” he said, adding that a number of SEP portfolio companies are currently in M&A discussions.

“During the downturn large companies cut back on IT research and development in response to falling profits,” he explained. “That has created a vacuum to be filled and as larger companies have recovered in terms of profitability, they are in a position to make acquisitions.”

According to a recent Goldman Sachs IT Spending Survey, after three years of cuts IT budgets are forecast to increase by an average of 3.5% in 2004, with a significant minority of companies planning an increase of 10%, which will fuel the drive for M&As in the IT sector.

“We’re also seeing a similar drive to acquire new technology in the oil and gas sector where companies developing technology aimed at improving safety or productivity are likely to be targets for larger players,” said Paterson.

In the life sciences sector, Paterson says the market remains cautious. US based life sciences merchant bank Burrill & Company agrees, predicting that the global biotech industry will raise at least $20 billion in 2004 but that better post-IPO share performance is needed to boost confidence in the sector in order to achieve this. Again, this points to the need for more mature companies with products at an advanced stage of clinical trials, a broad product pipeline and an appropriate risk strategy.

Looking forward to the second half of the year and beyond, Tom Attenborough of Citigroup believes that there is reason to be optimistic about the IPO market:

“Companies with a compelling value proposition are still being well received,” he said. “Even so, the balance of power currently rests with institutions. Investors are still nervous, and there are top-down concerns at a wider economic level to contend with. We believe that the IPO flow should continue however, given that the economic recovery appears durable and the fundamentals are good.

“While we may not see the completion of all deals in the pipeline - there is a further €50 billion of new issuance slated for Europe in the remainder of 2004 - the market still holds a great deal of potential for the right companies who choose the right time to make their move.”

Scottish Equity Partners (SEP) is one of the largest independent private equity groups in the UK, and is currently investing from a venture capital fund in excess of £100 million, which is backed by leading UK and European institutional investors.

With offices in Glasgow and London, SEP is one of the most active venture capital investors in the UK and has a strong investment track record. Typically, we invest between £500,000 and £5 million or more, in financings of up to £30 million, in early stage and growing companies in the information technology, healthcare & life sciences and energy related technology sectors. For more details visit www.sep.co.uk