London Dodges A Bullet With Arm’s U.S. Listing

(Bloomberg Opinion) -- The roadshow for semiconductor chipmaker Arm Ltd.'s flotation starts this week, and the mood music for the biggest initial public offering of the year, and one of the largest ever, has suddenly become more somber. Warning flags are fluttering as the SoftBank Group Corp.-owned unit has nearly halved the amount it plans to raise, and at a lower valuation range. After losing out to New York's Nasdaq Inc. for the right to host the listing, London Stock Exchange Group Plc may reflect on a lucky escape.

IPOs rely on buyers clambering over themselves to get hold of precious allocations. They are designed to be a feeding frenzy; technology sector listings especially. SoftBank has a patchy record when it comes to valuing and selling assets, and this crucial placement has been fraught with missteps. A failure to deliver a successful stock-market introduction and achieve a sustained healthy premium in the after-market could mar the global tech sector for months to come.

Any sale by private equity requires a larger amount of due diligence as the unit emerges into the bright light of public scrutiny of its accounts. In what appears to be a brazen attempt to pave the way for a blockbuster price, SoftBank bought a 25% stake in Arm from its Vision fund at an eyebrow-raising valuation of $64 billion only last month, a doubling of the 2016 purchase price. Furthermore, with $5 billion to $7 billion to be raised, down from initial indications for as much as $10 billion, Softbank will garner less than half of the amount it stumped up only a few weeks ago.

A recently reduced valuation range of $50 billion to $54 billion, from initial talk of as much as $70 billion, is hardly confidence-inducing. A private sale to Nvidia Corp. fell through last year at a $40 billion valuation due to regulatory concerns. With annual turnover of under $3 billion and adjusted earnings before interest, taxes, depreciation and amortization of $414 million, investors in Arm will be making an expensive bet on the future. The listing prospectus also showed some areas of faltering revenue, with China contributing a quarter of sales. Nasdaq won the listing not because of a deeper investor base — location is irrelevant to global portfolio managers — but because tech  companies command much higher valuations in the US. If anything, Arm would have been easier to place in London as it would automatically  qualify for the main FTSE 100 index, thereby requiring tracker funds to buy. Arm won't be in the S&P 500 index as it is deemed a foreign private issuer by the US Securities and Exchange Commission. 

Though it may seem more attractive for fund managers to pick up such a tantalizing asset as Arm at a cheaper price, given its monopoly grip on digital-data chips, that's not how equity capital markets roll. Hedge funds in particular tend to drive the success or failure of deals. As has become endemic across all types of new issuance, whether in bonds or equities, the size of buy orders submitted are often multiples of what a fund manager really wants. It's a big game of bluff, and the banks are the conductors. Large cornerstone investors may get hefty allocations, but it's opportunistic players that either provide momentum or undermine a transaction. It's all about the first-day premium to the listing price, as short-term speculation overshadows any fanciful notion of value investing. It's better to receive a smaller allocation at the top price than your full order size at the bottom end of the target range.

Lastly, if Arm was an easy sale it would in theory only need one lead manager to oversee the process. Instead, this deal involves pretty much all the leading investment banks, led by Barclays Plc, Goldman Sachs Group Inc., JPMorgan Chase & Co. and Mizuho Financial Group Inc. It's highly unusual to have four financial firms sharing the bill as joint-lead managers. Any of them could handle this on their own, let alone needing a wider subgroup of 24 additional underwriters. Morgan Stanley, which is the No. 1 player in tech investment banking, is a notable absentee.

As a further reinforcement, Arm's biggest clients have also been invited to the party, with Apple Inc., Intel Corp., Samsung Electronics Co. and Nvidia all participating as strategic investors.

The Arm listing isn't at any real risk of failure, but longer term the stock needs to be off the underwriters' books. There's a question mark over how large the overall order book might be. A multiple of the stock available for sale is the desired result, even with a placement of this magnitude, and the quality and holding pattern of investors also matters. Long-only fund managers flip their allocations into the after-market just as much as leveraged players, particularly if they decide their allocations are too small; sticky investors may be less plentiful if the stock comes in at too elevated a level.  

By trimming the terms just as the global investor roadshow starts, it's clear the lead managers are paddling furiously. It will require heavy lifting to make sure Arm's listing, expected next week, isn't just a success on day one, but that the shares perform well subsequently. For once, bankers may have to earn their prodigious fees. For investors, though, caution might be advised. 

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This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

Marcus Ashworth is a Bloomberg Opinion columnist covering European markets. Previously, he was chief markets strategist for Haitong Securities in London.

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