Private Share Market May Supplant IPOs

• Reinhardt Krause
• On 6:53 pm EST, Tuesday November 10, 2009

Here come stealth IPOs.

Nasdaq OMX, investment banks, venture capital firms and foreign companies are all zeroing in on the 144A market, in which private placements of company shares are sold mainly to institutional investors.

The 144A market has mainly been used by public firms raising capital via convertible debt offerings.

However, more private companies, both U.S. and foreign, are expected to use 144A rules to sell common stock and depositary receipts to institutional investors rather than file for initial public offerings.

Pre-IPO 144A equity offerings are not subject to Sarbanes-Oxley rules, which many firms view as burdensome.

As currently set up, the 144A market is friendlier to big equity offerings than to small companies backed by venture capital. In 2007, hedge fund Oaktree Capital Management sold 15% of itself for $880 million. But the National Venture Capital Association is pushing for broad pre-IPO regulatory changes to make the 144A market more functional for smaller firms.

In September, Nasdaq (NasdaqGS:NDAQ - News) and nine banks relaunched the Portal Alliance, a private placement trading exchange. Members include Goldman Sachs (NYSE:GS - News), Bank of America (NYSE:BAC - News), Credit Suisse (NYSE:CS - News), JPMorgan Chase (NYSE:JPM - News), Morgan Stanley (NYSE:MS - News) and Wells Fargo (NYSE:WFC - News). Nasdaq OMX and the banks first announced the exchange in 2007 but shelved it during the financial crisis.

The Portal Alliance, which integrates private exchanges run by Goldman and others, began trading Nov. 4. It expects a pickup in private offerings by foreign and U.S. companies and venture-backed startups as the U.S. economy rebounds.

"We're focusing on pre-IPO companies that may be VC- or PE- (private equity) backed who are looking for an exit strategy and foreign issuers that want to tap the U.S. institutional market," said Bob McCooey, senior vice president at Nasdaq OMX. "We think facilitating after-market trading, by consolidating 144A tranches in one platform, and getting more QIBs (qualified institutional buyers) familiar with companies, is how we can add value."

Under Securities and Exchange Commission rules, 144A placements are open to institutional buyers that manage more than $100 million in assets.

It's also technically open to "sophisticated" retail investors, defined loosely as having about $1 million in assets or having investment expertise. Retail investors, though, have not been big participants in the 144A market.

Foreigners Move Into 144A

In February, the Committee on Capital Markets Regulation released a 144A study. It reported "explosive growth in the use by foreign issuers of the private 144A equity market in the U.S."

Metallurgical Corp. of China -- which in October completed the world's second-largest IPO this year, listing in Hong Kong and China -- sold common shares to U.S. institutional investors in September. Chinese companies have been moderate users of 144A rules, completing only 10 such offerings since 2003.

Bank of New York Mellon says about 50 Russian, 31 Indian and 24 Brazilian companies have made private placements involving ADRs to institutional buyers since 2005.

BNY Mellon sponsors about 60% of 144A offerings that use ADRs in the U.S. Foreign issuers raised $9.8 billion via 144A offerings in 2006, the bank says. They raised $4.8 billion in '07 and $308 million in '08.

The Committee on Capital Markets regulation says using the ADR data "significantly understates 144A issuances because many foreign issuers now directly issue shares without using ADRs."

The advisory group says all types of 144A offerings accounted for 81% of equity raised by foreign companies in 2006; 24% in 2007; and 8% in 2008. So far in 2009, 144A use has rebounded at a 41% rate, says the Committee on Capital Markets.

Worries over the Sarbanes-Oxley Act, the risk of securities class actions, and compliance with GAAP accounting standards are reasons why more foreign companies are avoiding IPOs and doing 144A offerings, the advisory group says.

Institutional investors usually demand audited financial statements in private 144A deals. But companies can still avoid expensive and complex filings and full SEC reporting requirements.

Public companies have historically been the biggest users of the 144A market, mainly by issuing convertible debt securities.

In 2008, equity placements by public companies fell to $15.4 billion from $53.4 billion in 2007 as the credit crisis took a toll on the economy, according to a report by Boston-based law firm WilmerHale.

Something Ventured?

The pre-IPO segment of the 144A market is still small, says David Westenberg, a partner at WilmerHale and author of "IPOs: A Practical Guide to Going Public."

Westenberg says pre-IPO stocks trading in the 144A secondary market usually sell at a big discount because of the lack of liquidity.

"It's probably going to remain a niche market," he said. "Investors need liquidity or they won't invest.

"There is a lot of concern about the health of the IPO market. The NVCA has been saying the market is broken," Westenberg added. "The reality is that the 144A alternative is something few small companies have ever pursued. It's primarily designed for large offerings, not VC-backed companies."

In April, the NVCA unveiled its "four pillar" strategy to revive the IPO market and jump-start new ways for early-stage investors to cash out.

The NVCA aims to lobby for pre-IPO regulatory changes, including expanding the number of qualified institutional and accredited retail investors in the 144A market. The NCVA has also endorsed private trading platforms such as the Portal Alliance; startup SecondMarket; and Xchange, backed by venture capitalist Tim Draper, founder of Draper Fisher Jurvetson.

Six venture-backed IPOs took place in 2008. So far in 2009 there have been 10.

Problems with the IPO market run deeper than the recession, many in the VC industry say. Instead, they point 15 market-structure issues and the lack of investment banks that cater to small caps.

Specialists Alex Brown, Hambrecht & Quist, Montgomery Securities and Robertson Stephens were all acquired. Big banks aren't interested in underwriting small IPOs or providing research on small caps, some say.

Pascal Levensohn, founder of Levensohn Venture Partners and an NVCA director, says IPOs raising less than $50 million are becoming extinct. He says making the 144A market more liquid would help the VC industry. Attracting more institutional investors is key, he says.

"Historically with 144A, the issue has been very few players; it's not a well-populated area, and spreads were wide," Levensohn said. "One of the key improvements of the Portal Alliance is providing regulators with 100% verification of transactions. What's needed is improving liquidity, getting more players into the market."

The U.S. economy is being hurt by a declining number of publicly listed companies, whose investments fuel job growth, says a study released by accounting firm Grant Thornton on Nov. 9.

Shareholder Restrictions

Reforms in public and private markets are needed to aid small companies in raising capital, says David Weild, co-author of the study.

One problem with the 144A market is that if companies exceed 500 shareholders, they must file periodic financial statements to the SEC. That reduces the benefits of taking the 144A route. The 500-shareholder limit also hampers stock liquidity after private placements are done.

"If it's a market of accredited investors and qualified institutional buyers, why draw an arbitrary numerical line in the sand?" said Weild, a former vice chairman of Nasdaq and founder of consulting firm Capital Markets Advisory Partners.

Still, some observers urge venture firms to be patient.

There shouldn't be a "B-list" of companies that don't have the financial credentials to launch IPOs, says Kathleen Smith, a founder of Renaissance Capital, which tracks IPOs.

"An IPO is the gold ring; some companies can't grab it," she said. "A lot of companies that can't go public would like to find other ways to do so. But, 144A is not an IPO. It's a backdoor way of going public that isn't as liquid. It's more like a super-mezzanine of financing."

Buzz up!