What’s The Deal? | From IPOs to AI: Deep dive on tech investment banking
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Evan Junek: Hello, listeners, and welcome to What's the Deal? I'm today's host, Evan Junek from J.P. Morgan's corporate finance advisory team. And I'm excited to be joined by Chris Grose, co-head of technology investment banking for North America here at J.P. Morgan. Chris, welcome to the podcast.
Chris Grose: Evan, thank you for having me. Glad to be here.
Evan Junek: So great to have you here, love to just to know a little bit more about yourself, how did you get to J.P. Morgan, what has your career path been, and then tell us a little bit about what is technology investment banking at J.P. Morgan?
Chris Grose: Sure, I started my career at J.P. Morgan. So I've been in the business just under 20 years. I spent the first half of my career in New York advising companies across a number of different industries. And then in 2014, an exciting opportunity to join our tech practice which candidly was still pretty early in its infancy if you look at the progress that we've had over the last 10 years. I worked through a number of transactions. Ultimately, took on some operational roles, and here in the last 18 months have now taken the responsibility of managing our technology business for North America. As far as what our business focuses on and does, it's advising corporates, both private and public companies on their strategies. And that could be everything from raising private capital to raising public capital through IPOs and other types of offerings, as well as managing their capital structure and strategic advisory. There's so much going on in the technology space, and so it's certainly from my vantage points, one of the bright spots in the overall investment banking business.
Evan Junek: We just wrapped up our 51st Annual Technology, Media and Communications Conference or TMC Conference. It would be great to cover many of the themes discussed this week at the conference in a little bit more detail, including state of tech capital markets, the M&A environment, corporate clarity and separations and maybe even some of the latest developments of technology. But stepping back for a second, why do you think technology matters so much today and what does the path forward in the industry look like right now from where you sit?
Chris Grose: From my perspective, technology is the catalyst for innovation, and so it's transforming, as we all see, every industry, and each of our daily lives. It's just such an exciting time to work with these amazing businesses. Take global IT spend as an example, Evan, which is a pretty important barometer for how companies are investing. It's growing exponentially. If you just take the top 10 TMC companies by capex and R&D spend, that accounted for over $1 trillion of investments in 22 and 23 alone. And today, overall tech investment is now nearly equal to the investments across all other sectors in the United States. So related, it's probably not surprising to you that TMC now accounts for 35% of the S&P 500, and there's an aggregate market cap of over $17 trillion in this space. And I think if you add to that just the amount of dry powder looking to invest in tech, the space is pretty remarkable. There's over $1 trillion of VC and PE capital just waiting to be deployed. Now obviously the elephant in the room, layoffs, inflation, and a possible recession continue to drag on the industry. But, even despite these, I'll call it short-term challenges, there's pretty exciting times ahead, with major technological advancements, like AI, that's going to create enormous amounts of value. So, from my perspective, I've never really been more excited for what the future has in store.
Evan Junek: Well, I want to come back to AI. But let's start around the state of the markets today, and how the markets are approaching tech broadly. What do you think investors are really focused on?
Chris Grose: Today, we're in month 18 of correction, since the peak of the market in November of '21. The NASDAQ declined about 35% from the peak to the December '22 trough, and we're now about 20% off those lows, so still quite a bit a ways down. I think investors are really focused on three core macro areas. The first is the Fed. There's just a marked divergence in views of where the Fed goes from here. Our house view, as you know, is that we don't expect more rate hikes for this cycle, and that rates will stay steady at around 5% through early next year. But interestingly, the market is pricing in an interest rate cut in the second half of the year, with rates coming down to sub-4.5%, so I think it's pretty important that we get clarity on just what that looks like. I'd say the second key topic is an understanding of the possibility of a near-term recession or whether we're already in a recession, just where we go from here. I think no matter who you speak to, there's pretty broad consensus that there's likely to be a slowdown in the back half of this year or early next year, but the good news is, is we've seen continued consumer health, and corporate earnings have been actually rather resilient. So, the expectation that there's an economic downturn on the horizon, I think is that, yeah, sure, and perhaps it will come. But it's more likely than not to be mild, and even if it is severe, I just think there's a widespread mindset of like, "Let's get this over with, find the bottom, and start to march upwards from there." And then I'd say the third point is the ongoing geopolitical risk. I think it's the one element of the three which, candidly, is unknown, and could have pretty material impacts as to what the outlook looks like. And so, whether that's question marks around China's reopening and the stance towards tech, the ongoing Russia-Ukraine conflict, just to name a few. So, when I look at those events I do think overall, we expect volatility to continue in the commodity markets, FX, as well as in, in overall equities.
Evan Junek: I think that's well summarized. Risks of rates and corresponding policy, recession risk, geopolitics. How do you see those factors impacting sentiment for tech companies generally?
Chris Grose: It’s a great question. I just think overall conservatism is the mindset. If you look at where multiples have gone in the tech industry over the last 18 months, we saw a pretty sharp correction in early '22. Investors have shifted their mindsets from growth at all costs to seeking proof points for sustainable margins, consistency, and durability. And if I look at software as an example, which I think is a pretty good barometer for tech, the average forward revenue multiple is down from roughly 11 times in '21 to just under four today. Which if you look over the long-term average, it's about five times forward revenue. So, there's certainly been a pretty significant pullback in valuations. And maybe to further illustrate the point, there's just been a shift in investor mentality from growth at all costs. At the peak of '21, a point of revenue growth was worth nine points of free cashflow margin. Now, fast-forward to today, that ratio has meaningfully shifted. A point of revenue growth is now worth just two points of free cashflow. So, you can kind of get a sense of where people are focused, and investors have said, "Rule of X is what matters. I want a balanced approach to both growth and profitability." If you look at the best-in-class companies today, that are, let's say 25+% revenue growers, and 50 rule of X companies, they're trading at a premium multiple. And, if you actually look over the last two decades, companies with superior free cashflow have outperformed the broader market by almost four times. And so, we expect this trend to be here and to continue for the foreseeable future.
Evan Junek: When you talk about Rule of X, we're talking about this idea that firms who have a baseline-level of margin and growth that sum up to X. In your example, rule of 50 being growth plus, let's say, free cash flow margin, between those two that would add up to 50, just to contextualize that for the audience. I think the key point there, and we're seeing it even across other sectors as we do work ourselves, is, a general shift, not entirely away from growth, by any stretch of the imagination, but certainly with a much greater focus than we saw 18 or 24 months ago on margin, on cash flow, and on profitability.
Chris Grose: Exactly.
Evan Junek: Translating that to a more specific aspect of the market what do you think that really means for the tech IPO market? How do you see that evolving?Chris Grose: We're in a period of time where the tech IPO window has been closed for really 18 months, and this is now the longest hiatus since post the global financial crisis when the IPO window was closed for 14 months. There's been four tech IPOs that have priced in 22 and 23 year-to-date versus 112 in 2021 at the peak. If you just look at more normalized markets, we still typically see about 35 to 40 tech IPOs, or about a third of the overall IPO market. So, there's been an incredible gap in new issuances come to market in tech. I would say we are starting to see some green shoots. There's been some successful IPOs across other sectors, which, hopefully, is an indicator of a broader reopening here in the second half of the year. I will say the pipeline, though, is quite strong. We've got a handful of scaled, profitable, and growing companies that will potentially test the market, whether it's later this year or early next year, and I think that that will hopefully be the start of a flood of companies thereafter.
Evan Junek: Chris, maybe expand on the factors that would drive an opening of the IPO market.
Chris Grose: I would say there's three factors when we're speaking to investors that they're focused on. The first is just a recalibration of pure multiples. I think that's more or less effectively taking place at this point. Pure multiples are now at a place where investors feel like there's a good entry point. The second is just what the macrostability is. Again, fed clarity, as it relates to potential rate cuts and the inflationary environment, is still unclear, and until there's more clarity there, I think that things are gonna be on pause. But once that actually starts to work itself through the system, investors will be able to get confidence in the 24 and 25 growth outlook, and these businesses, as a result of a lot of what we've spoken about, now are very focused on profitability at the same time, which gives you a pretty good setup into a new range of IPOs coming to market.
Evan Junek: Given the IPO market is so quiet, what have you been seeing on the MNA side of things?
Chris Grose: It's been rather tempered, as well. I think if you just look at LTM Global MNA volume, during the peak, so, let's say roughly November of '21 and compare it to today, volume is down about 65%. Equity issuance, just to give you a frame of reference, is down 75%, so, it's not a whole lot better. Companies are just more cautious and more selective in their MNA targets. And because of the backdrop with the market volatility, we've just seen a wider range of value expectations and therefore larger bid ask spreads, which have led to some pretty difficult conversations around price negotiations in a deal context. If you also add to the fact that the current regulatory environment widely covered in the press, more deals are facing anti-trust scrutiny. So, I'd say those kind of confluence of factors have led to a pretty cautious tone around MNA. Now, what are the bright spots? The bright spot is that the tech industry is continually representing a higher percentage of total MNA activity. So, today it's about 25% of total MNA volume, and that's up from high single-digits 10 years ago. There's gonna be continued MNA, but it's just the pace that's the question. And I do think the positive downstream effects of any time you have an economic cycle run its course, corporates have huge cash balances, they're gonna be there to deploy it, and they're gonna happen to be deploying it at a pretty attractive valuation entry point. So, I'm optimistic about the MNA environment over the next 18 to 24 months, once some of these macro points work themselves through the system.
Evan Junek: I think it's been said that necessity breeds creativity, and I'm curious to know if you've seen deal structures change a bit in this environment as a result of some of the factors you've just mentioned.
Chris Grose: Yeah, we absolutely have. If you look at public market valuations, they've more quickly reflected the market conditions than the private market, and therefore, there's been an increased focus on take privates. So, the MNA volume in private equity has actually been one of the bright spots. And that's partially driven by a record amount of sponsor dry powder, as I mentioned earlier, and we continue to see a number of firms raising massive new funds. While the debt markets have been a bit more resilient than the equity and MNA markets, we are, though, experiencing a decrease in the willingness of debt investors to participate in really highly-levered situations, which has constrained the amount of cash that can be there to fund transactions. And so, one, you've seen a little bit of a structural change on how deals are being financed, alternative financing or direct lenders has certainly been one of the key themes in the LBO context. And the second is around minority deals. Minority deals actually represent about a third of all deal activity over $500 million in the last two years. And those number of minority deals, in my view, are expected to continue to grow, primarily because of the change of control debt financing triggers in transactions. You wanna be able to keep the cheaper cost of financing that was put in place a few years back, versus what the cost of financing is today. In this new paradigm, this is what we're managing our clients through. So, I do think deal structure creativity will continue to be at the forefront of how things get done.
Evan Junek: Let's shift gears a little bit. We've seen a pretty substantial pickup in shareholder activism activity. How do you see that impacting the tech space right now?
Chris Grose: Maybe to put a finer point on it, just around the increased volume that you mentioned, so, in 2022, campaign volume was at its highest since 2015, and it was actually up 35% even verse '21. What we're seeing is campaigns mainly demanding strategic changes from management and urging companies to focus on greater corporate clarity. Activism campaigns are becoming more and more common in the tech industry, and actually, about a quarter of all '22 activism campaigns were technology. So, I think it's interesting to first start with where are activist pushing for change. The first is the importance of growth versus profitability, what we were speaking about earlier. And we've seen this impacting activist campaigns as they've been very focused on a healthy balance of growth and profitability, the rule of X that you spoke about earlier, Evan, and making sure that companies are optimizing and rationalizing their spend. And we've seen that a number of tech companies have announced corporate restructurings, and cost removal from the system in order to get to profitability sooner. I'd say we've also observed a couple of other key trends in activism. One notable one is that top institutional investors have become more open to siding with activists in proxy contests. And I'd say maybe the point that's even the, probably the most eye-opening is that no one company today is really protected. So, companies who have meaningful insider ownership, or they have multi-class share structures, they're now at risk. And so, in situations where performance has been weaker than expected, there has been an immediate focus around activists approaching those businesses with a heightened focus on the board, what are the governance policies, and ultimately, focusing on the cost structure of those businesses. The last point I'd say is that when I think about what to expect going forward, I'd be watching closely two trends. The first is the expiry of the sunset provisions for companies that have dual class structures, so that will certainly start to come to light given many of these businesses have been public now for five, seven, 10 years. And the second is the new universal proxy card rules which we think will likely result in an elevated amount of proxy fights.
Evan Junek: You mentioned in some of your comments around activist demands this theme of corporate clarity. Can you talk about recent trends around that and what you've seen with respect to tech?
Chris Grose: Corporate clarity remains pretty robust across the market, even in the face of, as you alluded to, general market uncertainty. The fact that US corporate separation announcements were up about 40% from '21 to '22, I think tells you a really everything you need to know in that corporates are looking for ways to create shareholder value, and if it cannot be done as diversified entity, they're then thinking about, "Is there ways for us to spin off pure play growth businesses in order to create incremental value for shareholders?" The facts are that, roughly, pure play companies across the market traded about a three times PE ratio premium to more diversified companies. And so going forward, irrespective of what the market backdrop looks like, we expect separations to remain a pretty popular strategic option for really three reasons. The first is the self-help path, if you will, doesn't require an M&A counterparty or an IPO window to be there. Two, it creates optionality for you if you're also thinking about a potential sale or merger, so there's sometimes competitive dynamics at play. And then the third is that the precedents have proven to create a bunch of shareholder value. If I look at high growth companies, and compare pre-separation with post-separation, we see about a 30% uplift in trading multiple. If you're a CEO in a board today, trying to find 30% uplift in your trading multiple is pretty difficult. So, if there's an opportunity to streamline your operations, corporate clarity I think is one of the key things that people are gonna continue to turn to.
Evan Junek: Well, I told you we'd come back to it at the beginning. I don't think any podcast on tech would be complete at this juncture without a question about AI. Where are tech companies and investors most focused with respect to artificial intelligence today, sort of the hottest of the hot topic of the moment?
Chris Grose: Certainly investors have become acutely focused on companies' ability to navigate the impacts of AI. Both in the near term, but really more focused on what the medium and long term impacts are, since we're still pretty early in the infancy of AI. I'd say it's pretty difficult to actually track the trajectory of AI, but the positive ranges, you can think about it as, like, product set improvement, cost base optimization, efficiency, I mean, there's a lot of things that start to impact a company's success if they're able to implement AI. And we are seeing companies aggressively trying to get in front of this disruption, by addressing their AI product, and competitive positioning. I think if you look at the most recent earnings for tech companies, it tells you everything you need to know. The number of references to generative AI in recent tech earnings calls were up 60 times versus just two quarters ago. And if you look at the range of outcomes in earnings last week, or over the last couple of weeks, they've ranged from stocks down 50%, where AI was perceived to be an existential threat, to up 25% with investors repositioning into companies that are perceived to have beneficiary tailwinds with AI. The thing that you just have to be focused on in our business as an investor, and for a corporate is that we are just in the very early days of AI. There's been 200 billion of venture capital that's flown into AI since '21, and AI now constitutes nearly 50% of series B+ funding, year to date. One out of every two is an AI company (laughs). So, you know, it kinda tells you where the future is going. There's a bunch of different market reports out there, but one that I saw estimated that AI will contribute over 15 trillion dollars to the global economy within a decade. So if that's even remotely close to accurate, this is where every company is gonna be focused. It's a very exciting time in tech we are thrilled to be at the forefront of helping several of these leading companies of the future unlock these massive opportunities and pretty exciting time to be in and around everything that's happening in technology.
Evan Junek: Look, there is no shortage of fascinating topics we could hit on when it comes to technology strategy and the markets, but unfortunately, we are out of time. So, Chris, thank you so much for joining me today and sharing your insights.
Chris Grose: Evan, It was my pleasure
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