Issuers need to lower expectations, says Cazenove

The chief executive of the mid-cap focused investment bank predicts a challenging year ahead for primary issuance.
In a year when equity deal sizes are expected to shrink as a result of lower valuations and a more selective investment approach by the buy-side, it is reasonable to expect that mid-cap issuers will account for a larger portion of the overall market.

Cazenove Asia is an investment bank that focuses primarily on the mid-cap segment (which we define as companies with a market cap of about $1 billion, or deal size between $100 million and $300 million). Last year it was the sole arranger of the $210 million initial public offering for noodle restaurant chain operator Ajisen China, which was awarded by FinanceAsia as the Best Mid-Cap Equity Deal in 2007. And this year it has already been in the market with a $144 million IPO for Changsheng China Property (together with BOC International), although like the other three companies that were pursuing a Hong Kong IPO last month, the listing was postponed due to the volatile market conditions.

We ask CEO May Tan about her expectations for the equity capital markets this year.

It has been a difficult start to the year in Hong Kong with several IPOs pulled or postponed and continued volatility in the secondary market. What do you expect from 2008 in the context of that?
We are coming off a very strong base in 2007 and with that comes potential difficulties. For a start, a lot of the mandates that we will be executing this year were won last year, which means issuersÆ expectations are considerably more optimistic that what current markets will permit. So, there is a certain amount of persuasion, adaptation and adjustment that needs to take place.

Given what has happened in the US, I think we will continue to be very fixated about statistics such as housing stats, consumer confidence etc., which is something we see with every cycle. ItÆs like skiing, when you are going down a slope you look at what is in front of you and that is always a rather painful process. Consequently, I expect that the volatility will continue in the first half and that secondary market volumes will decline. And as a result I think 2008 is going to be a more challenging year overall.

Credit will be an issue throughout the year. Banks will constantly be watching their credit policies and who they lend to. It is a natural reaction. On balance though, IÆm not too bearish because I believe that what is happening in the US will actually cool down the Asian economies a little bit. For instance, in China, we may even see the government stop putting up rates and increasing reserve ratios, allowing the market to start focusing on good news for a change. If things really do slow down considerably, then maybe there will be room for China to even cut rates a little bit.

Do you think this focus on credit û and banks holding on to their purses a little tighter û could be a driver for the primary equity market?
Yes, definitely. You see it already in certain sectors, that companies go to the equity market instead of to the banks and I think there will be more companies wanting to do that. But you have to weigh the access against what kind of valuations they can get in light of the tighter credit and its effect on the markets.

You think it is going to be a more challenging year. How are you positioning yourselves right now to deal with that?
For a start IÆm telling my traders to be extremely careful and thatÆs not because of rogue trading. In this volatile a market û if you make a mistake, itÆs very costly. You could be talking about a 10 spread move before you are able to cover your position. In these kinds of markets you really do need more eyes on the desk.

On the investment banking side, we are talking to our clients and trying to educate them on what the markets are doing. If you are not in the business and are just reading the headlines, itÆs pretty frightening. So talking to corporate clients, explain to them what our outlook is and to a certain extent, managing their expectations early is important.

How does Cazenove go about convincing issuers that they may have to lower their expectations with regard to the valuation and size of their upcoming deals?
The key really is to look at their businesses overall. The macro picture in China was very good in 2007, but if inflation persists, costs will go up. Given what is happening in the States, for exporters the outlook for 2009 may not be that strong. ItÆs not just about looking at market valuations per se, but to tell them that their businesses are not going to grow by the same magnitudes as before. The market has been looking at PEG (price to earnings over growth) and when your G is not as high as it used to be, you really need to adjust to that.

At this point, are you recommending your IPO clients to hold off and wait for the volatility to come down to get a more stable floor to base the valuation on?
It all depends on the clientÆs funding needs. At the end of the day, although China is awash with liquidity, banks have been rather resistant to lend and reserve ratios have been raised, which have meant that some companies find it hard to get bank financing. So, even though the amount of equity they can raise will be lower because of the pricing, if they are seeking money for capital expenditure and have got a project with a tremendous IRR (internal rate of return), I would still encourage them to go ahead and bite the bullet. But if a company has managed to get private equity funding and can call on them for additional capital through a rights issue, then I wouldnÆt recommend that until the volatility is over.

With valuations now reasonable quite a lot of our clients are also keen to do more M&A. The raised money last year and now they want to go shopping.

Aside from its mid-cap focus, Cazenove is known for working primarily with private-sector companies. Other than that, what would you say is important for the firm when seeking out clients that need funding?
First of all it is always a case of playing to our strength. We want to make sure that we have the research capability on the secondary side, that we have the ongoing support. Although one doesnÆt typically think of mining as mid-cap, there are mid-cap miners in China and in 2006 we arranged Zhaojin MiningÆs IPO. This is an industry that is going to see some consolidation and we have a very strong mining franchise because of our corporate relationships in London, which include Rio Tinto and Anglo-American. Another sector of interest is oil & gas support. We have three analysts who look at both mainstream oil & gas and support businesses like equipment, drilling services, dredging, supplying tug boats etcetera and we have been talking to quite a few candidates in Singapore.

What type of companies do you expect to bring to market this year? Will there be more retail-focused issuers like Ajisen?
Our pipeline includes companies from different sectors. I would say our focus is not necessarily on retail, but on consumption. Consumer/retail is an area that is very fragmented and dominated by companies that were started by entrepreneurs. I think there is still good appetite for these. The only reservation is that valuations may be affected by market sentiment.

In your view, will it be possible to bring an industrial/manufacturing company to market in these kinds of conditions when everyone is so focused on the possibility of a global recession?
If it is an export play I think it is going to be very difficult, but if it is an industrial company that is providing equipment to the Chinese infrastructure or building materials sectors, then I think it is possible. If it is a company selling to the US or even Europe, I think it is going to be tricky. And donÆt forget, this isnÆt just due to a slowdown in demand, but to rising material prices as these companies are still finding it hard to pass on raw material costs. And now we have new labour laws coming in that will push up labour costs.

Last year Cazenove acted as a bookrunner on three IPOs in Asia ex-Japan and were involved in a total of 12 equity issues, which was down from five IPOs and 13 issues in 2006. How does your pipeline for 2008 look?
We are in a very fortunate position of having a good pipeline for 2008. Markets permitting, in terms of number of IPOs it is probably going to be closer to what we did in 2006. We should also be able to do a couple more block trades. One reason is that we did quite a few listings in 2006 and according to the cycle - two yearsÆ later they will have used up the money. This means there will be an opportunity to work with the same companies again.

In 2007, Chinese companies raised about $16.1 billion from the mid-cap segment of the market, (about 12% of the total ECM fund raising out of China), according to Dealogic. Any chance that we could see as much volume in 2008?
The wild card is always going to be demand. If you are a CIO based in Europe or New York and you believe the US is in recession and Europe is slowing down, you will put more money into Asia purely by default. In that case we may see the same volume for mid-caps this year. Also, there arenÆt that many very large-cap companies in the pipeline for this year, so there should be more money left over for the mid-caps.
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