The headline was a bit of a teaser – revenues and earnings at both Goldnam Sachs (GS - Free Report) and Morgan Stanley (MS - Free Report) are accelerating and Q1 2018 results came in above estimates on virtually every line - but Spotify’s (SPOT - Free Report) recent “Direct Listing” IPO does pose some potential challenges to the traditional equity underwriting business at the Bulge Bracket Investment Banks.
Let’s examine what the impact might be.
Industry Leaders Dominate the IPO Action
You’ll recall that when the streaming music giant went public this month after more than 10 years as a private company, they used the relatively rare process of listing directly on the NYSE, rather than the much more common strategy of an investment bank-led IPO.
In the traditional model, a company that is ready for public trading enlists the services of one or more investment banks to aid them in selling the shares for the first time. In return, the banks generally keep some portion of the shares for themselves and/or charge hefty fees for their efforts. The banks then utilize their connections with vast numbers of institutional clients to gauge interest in ownership of the shares so that they can price the offering efficiently.
Usually, the company being brought public is primarily seeking to raise cash by selling shares to fund current and future operations.
It’s common practice for the actual IPO price to be slightly below where the market seems to be interested. This allows the purchasers of the shares to enjoy an immediate return as the market price rallies above the IPO price they paid. It’s somewhat of a balancing act for the banks. If the shares don’t rally at all (or decline) following the IPO, the deal looks like a failure for investors, dampening demand for future deals. If the shares rally too much, it looks as if the bank left money on the table for its underwriting client. A 10 -15% gain in early trading is the “sweet spot.”
Goldman Sachs and Morgan Stanley dominate that market for equity IPO underwriting in the U.S., especially for large deals.
Spotify Bucks the Trend
By choosing Direct Listing, Spotify chose to forgo the guidance of experienced underwriters and cooperation of big institutional investors in selling their shares. They also didn’t raise any capital for the company itself – the shares that traded were sold by company insiders and early investors. Spotify itself didn’t raise a dime.
At the time, Spotify claimed that the listing was a step toward democratizing the offering process, something they claimed to be especially sensitive to after having dealt with large record labels who they felt acted as the “Gatekeepers” for music. They wanted to avoid dealing too much with the Gatekeepers of Finance.
Spotify also took considerable risk in the price movement that the shares might experience. The traditional model encourages investor interest that customarily keeps the price supported at or above the IPO price. In a direct listing, the shares could easily fall precipitously if the company has misjudged investor demand.
As it happened, the listing went just fine, and the shares are now trading slightly above the valuation previously assigned to the company in the private market. Spotify saved an estimated $65M on underwriting fees, paying approximately $35M in consulting fees rather than the estimated $100M they would have paid traditional underwriters.
Will Everyone Else Do It Too?
If Spotify could do an end-run around the traditional IPO process, save a bundle in fees and get a similar result, does it mean the traditional market is dead and underwriting fees are about to dry up?
Not by a longshot.
Only already well-known consumer companies that get extensive media coverage could even consider making a direct listing work. There were 3,394 IPOs in the United States between 1999 and 2017, an average of 179 per year. Out of those deals, only 160 had market capitalizations above $50M. Obviously, the vast majority were not household names - even in the finance and investing communities. Smaller companies rely heavily on the assistance of the underwriters to explain their businesses and financials to prospective investors.
It’s possible that a few companies that have been through multiple rounds of venture capital financing, already carry huge valuations and sell products and services that are very visible to the public might be able to pull off direct listing the way Spotify did (think Uber or AirBnb), but the vast majority of new issues are much better served by the assistance of traditional underwriting.
Two Final Considerations
What if, however, direct listings did become popular? How much would it hurt revenues at the big underwriters?
The answer? Not much.
In Q1 2018, Goldman Sachs took in Equity underwriting revenues of $410M; Morgan Stanley took in $421M. This is versus total revenues in the quarter of $10 Billion and $11.1 Billion respectively. While underwriting is a lucrative profit-center for the banks, it represents a tiny portion of revenues at these huge and well-diversified financial powerhouses. Losing a few deals per year would hardly be noticeable at the top or bottom lines.
Finally, there is some speculation that Spotify’s decision to use a direct listing was not entirely motivated by the desire to democratize the offering, but also included a bit of clever financial engineering. In 2016, Spotify took on $1B in debt in the form of convertible debt from TPG and Dragoneer that allowed the lenders to convert increasing amounts of shares the longer an IPO was delayed. The direct listing allowed Spotify to satisfy the terms of the agreement with a minimum of dilution.
TPG and Dragoneer both converted all the shares they were entitled to and immediately sold most of them to Chinese company Tencent at a nearly 100% profit, so the deal ultimately worked well for them as well.
There were a very unique set of circumstance surrounding the Spotify offering that are unlikey to happen again soon. The market for traditional IPO underwriting service appears intact for the foreseeable future.