2021 was an exciting year for initial public offerings (IPOs) and placements. 55 companies with an offer price greater than A$20 million made their debut on the ASX during the year. Up a staggering 62% from the year before! Secondary placements experienced a more modest increase, up 6% from 2020.

Most equity capital market (ECM) activity took place in the small cap end of the market. Providing a material opportunity for institutional small cap managers like Firetrail to add value for their investors.

In this article, we analyse the success of small cap IPOs and placements in 2021, provide key takeaways for investors, and what to expect in capital markets in 2022. We conclude that corporate activity will remain elevated in small companies throughout 2022. Creating meaningful opportunities for investment managers willing to do the work to identify the best opportunities.

IPOs and placements outperformed in 2021

It wasn't just the sheer number of IPOs and placements that broke records in 2021. Together, new ASX-listings raised a total of A$12 billion! Among them were a record number of billion-dollar floats, such as APM, SiteMinder and PEXA.

On the first day of trading, these IPO companies outperformed the market by an average of 20%. However, we did see this outperformance moderate by the end of the year.

We saw the inverse occur in the market for secondary offerings. Average day one performance hovered around 10.1%. While calendar year performance rose to 15.4%! The total amount raised by secondary offers was A$37.7 billion.

But that doesn't seem like an accurate reflection of performance from a market perspective.

Careful stock selection is critical

If we adjust for the size of the raise, the story changes. We see big declines for first day and calendar year performance for both IPOs and secondary placements. Suggesting that the relative performance is skewed by a handful of big winners.

In the IPO space, performance was dominated by a few key players. DGL, a chemical manufacturing and storage group, and Trajan, an analytical science and devices company, experienced greater than 100% returns in the calendar year.

To account for this asymmetry, we took the median performance for the calendar year. The median return for IPO stocks was just -4%. Providing a more accurate reflection of capital market performance.

Clearly, an ability to pick winners is key to harnessing value from corporate activity. The chart below compares the relative performance of IPOs that raised more than $50 million. While average performance was strong, there were more losers than winners.

Through deep fundamental analysis, Firetrail were able to pick the winners this year. The median return from our IPO participation was 18% for the 2021 calendar year (shaded in grey in Figure 1).

Careful selection is also key for managers trying to maximise returns from secondary placements. In 2021, we saw a wide dispersion in results.

The best returning secondary issuances were in companies in need of balance sheet repair. The average placement in this category delivered 33% excess. In many instances we observed that the 'raise' was already priced in by the market. Hence recapitalisation was the catalyst to refocus the market on business fundamentals.

The market also rewarded companies raising capital to grow organically far more than M&A. Raisings for growth dominated the market (Figure 3). In contrast, there were few M&A bargains in 2021 due to intense competition for assets. Many companies were willing to pay listed multiples for strategic acquisitions.

Opportunities will remain elevated in small caps in 2022

ECM events are a consistent source of opportunity and strong returns for small cap investors. Access to these opportunities is key, and the Firetrail team have a strong track record of leveraging our corporate relationships and fundamental expertise to access attractive corporate opportunities for our investors. Since the inception of the Firetrail Team's Small Companies strategy in 1998, previously the Macquarie Australian Small Companies Fund, these events have contributed an average 20% of the total excess returns, or ~3% p.a.

Looking ahead to 2022, low interest rates and high valuations will continue to encourage companies to raise capital. We expect ECM activity to remain elevated and to continue delivering material opportunities for small cap investors like Firetrail.

Conclusion

2021 was a year of frantic ECM activity and we see no sign of this abating as we move through 2022. As small cap investors, we are excited by the opportunity and potential returns offered by IPOs and secondary placements in the coming year. Our experience shows that meaningful returns are out there if managers are willing to do the work to find them!

Funds operated by this manager:

Firetrail Absolute Return Fund, Firetrail Australian High Conviction Fund

In 1997, Jeff Sprecher of the US, who had spent years developing power plants, decided to provide transparent pricing to the US power market. Well before electronic trading of financial securities became the norm, Sprecher paid US$1 for a tech start-up so he could build a web-based trading platform.

For three years, Sprecher and his team met oil, natural-gas and power companies to learn what people sought in a trading platform. Some of the innovations that resulted included pre-trade credit limits, counterparty credit filters and electronic trade confirmations - novelties taken for granted now. By 2000, the trading platform was set for launch. Sprecher renamed the shell company Intercontinental Exchange to highlight the trading platform's ability to cross oceans, let alone borders.

In 2001, the International Petroleum Exchange of London wanted to evolve from floor to electronic trading. At the time, the exchange was a regional one that offered oil futures contracts and had less than 25% share of the global oil futures market. Intercontinental Exchange, which promotes itself as ICE, saw an opportunity to branch into energy futures and clearing and purchased the exchange. Thanks to the ability of ICE's platform to increase price transparency, handle high volumes efficiently and lower transaction costs, the volume of oil futures traded on what is now called ICE Futures Europe swelled. A regional exchange grew into a global one.

From 2007, the year ICE listed (with the ticker ICE), the company went on a buying spree of exchanges. The company snared the New York Board of Trade, which barters commodities such as cocoa, coffee and cotton, ChemConnect, which trades chemicals, and the Winnipeg Commodity Exchange, now ICE Futures Canada that mainly trades canola. A sign of ICE's ambitions was the company's failed bid that year for the commodities-based Chicago Board of Trade.

Undaunted, the ICE takeover quest continued such that ICE, which earned US$6.6 billion in revenue in fiscal 2020, owns an exchange arm that boasts 12 global exchanges and six clearing houses that service the energy, agricultural and financial sectors. The haul includes the purchase in 2013 of the New York Stock Exchange, the world's biggest by volume. Among feats, ICE hosts nearly 66% of the world's traded oil futures contracts and is the world's leading clearer in energy and credit defaults. On top of that, ICE's exchange arm manages key global benchmark contracts. This list includes Brent oil, Euribor, natural gas, sterling short and long rates and sugar barometers of performance.

In recent years, ICE has branched out such that the exchange business, which brought in 55% of ICE revenue in fiscal 2020, is one of three divisions. The second arm, responsible for 27% of revenue in fiscal 2020, is the fixed income and data services business that sells data and technology to help investors make and execute decisions. ICE assess prices for roughly three million fixed-income securities spanning about 150 countries in 73 currencies, as well as providing advanced analytics and indexes for fixed-income markets.

ICE's other business is mortgage technology, which pulled in the remaining 18% of revenue in fiscal 2020. This arm has digitalised the mortgage process to reduce costs and increase efficiencies. The ICE mortgage business is the largest to automate the entire process, is the industry's leading platform with more than 3,000 customers, partners and investors, and the industry's only loan registry. This platform offers significant growth potential as more US mortgage originators are expected to turn to ICE's digitised offering.

ICE is a promising investment in three ways. The first is that the exchanges and other businesses possess sustainable competitive advantages that form a daunting 'moat' for the parent company - where moat is a colloquial way to say a company is protected from competition. Most of ICE's earnings are derived from trading and clearing fees from the exchange businesses and linked data. These businesses are moated because they enjoy economies of scale, network effects and industry structure that intimidate would-be competitors. Another moat for ICE is that when it comes to derivatives and listing, there are limited substitutes. The holder of benchmark contracts is favoured in negotiations, even if others are seeking to undercut on price.

A second advantage ICE enjoys is that the company is vertically integrated - it controls the execution and clearing of contracts. This enables the company to exert pricing power, attract volumes, and improve counterparty and systemic risk management.

The other advantage that makes ICE an attractive investment is the company is well managed. While ICE has a history of disrupting others, the Sprecher-led team has prevented ICE being disrupted. Management has steered the business towards attractive industry structures (derivatives exchanges), unique data sources and value-add analytics. As important, the team has largely directed ICE away from equities exchanges, where regulation and technology have upended the pricing power and volumes over the past 15 years. All up, ICE is well placed to provide compounded returns for its investors for the foreseeable future.

ICE, as do all businesses, faces risks. One is that the company's revenue is tied to trading volumes over which it has little influence. The fact that trading volumes often increase in turbulent and falling markets means that ICE is well placed to weather a market slump that falls short of a prolonged 'bear market' where trading was light. ICE's other risk is that its business is exposed to adverse changes to regulations. Moves by regulators to separate execution and clearing, and actions that might reduce trading volumes, would disrupt ICE's revenue. ICE is protected to some extent in this regard because regulators are aware that such moves against exchanges, especially ones that feature large derivatives trading, would boost trading costs, hamper innovation and, possibly, increase systemic risks.

ICE, thus, is well placed in a world where Sprecher's vision has helped electronic trading become the norm.

Sources: Company filings and website.

Apparently, Confucius did not say "One Picture is Worth Ten Thousand Words" after all. It was an advertisement in a 1920s trade journal for the use of images in advertisements on the sides of streetcars. Even without the credibility of Confucius behind it, we think this saying has merit. Each month we share a few charts or images we consider noteworthy.

You may have noticed that the tech sector has been under pressure lately. Bank of America's monthly fund manager survey shows allocations to the sector are at the lowest point since 2006 - yet in the unlisted world CB Insights has tallied up a surge in "unicorns" to 1,000! Totus Capital made a great point on the significant dispersion between different tech companies' accounting treatment of R&D spend. And ASX-listed fintech Douugh's "accumulated revenue" chart, as highlighted by  @lukewinchester9, was definitely an innovative approach to presenting financials. On the COVID-19 front, Bloomberg shows global air traffic is still less than half pre-pandemic levels, while The Economist shows most countries trending back towards "normalcy" - with China a notable exception.

Tech net allocation at lowest level since 2006

Source: Bank of America (via @daniburgz)

Now there are 1,000 unicorns

Source: CB Insights

Huge differences in how ASX software companies account for R&D spend

Source: Totus, livewiremarkets

Accumulated revenue chart by ASX-listed Douugh (DOU)

Source: Douugh Limited, @lukewinchester9

Global air traffic less than half pre-COVID level

Source: Bloomberg

The Economist's "Normalcy Index"

Source: The Economist

It was all about "chips" - semiconductors - in 2021and likely also in 2022. We (internally) break down our portfolio into three categories - those that produce the tools that enable disruption ("tools"), those enabled by these tools ("enablers") and a group of more downstream beneficiaries ("beneficiaries"). It's not the only way the portfolio is split, but it is a useful way to understand how value in disruption can be tracked.

This understanding resulted in a significant weighting toward the "tools" companies during the year, including semiconductor designers, makers and suppliers such as Qualcomm, Nvidia, AMD, Marvell, Taiwan Semiconductor Manufacturing Company (TSMC), Samsung and ASML.These companies are the equivalent of pick and shovel makers in a goldrush. They may not perform as strongly as the best miners, but they do produce a steadily-growing and valuable cashflow stream. And they are not as subject to failure if a particular "mine" (social media platform maybe, or app) doesn't work.

It's an area in which most investors do not participate. However, it is correct to say that the new disruptive business models which have created so much value for shareholders would simply not have emerged but for the increasing sophistication and sheer grunt of the chips on which they run.

Earlier this week, for example, the agricultural machinery company John Deere debuted a new autonomous tractor with attached tillage equipment at the CES trade show in Las Vegas. Deere's director of emerging technologies stated the tractor can run fully driverless at all times while tilling, saving significant time and labour. The company has stated it intends to expand the technology to include planting and weed control.

The scope of this is enormous. The feed from cameras, radar and possibly lidar (light detection and ranging) must be fused into a single moving picture - although it is not a picture, since every element of it must be 'interpreted' (and so involves graphics processing units, or GPU's, tied in to the central processing units, or CPU's). All of this intelligence is then used to drive the actuators which steer, till and spray across the mapped field. This is automation writ large.

The essential tools for these use cases are GPU's by the likes of companies Nvidia and AMD (which together generated +4.1 percentage points of return for Loftus Peak investors in 2021).

Companies such as these have created interlocking value loops with each other. A Google-map search for directions may take place on a Samsung phone, using a Qualcomm processor, to then be stored in a Microsoft Cloud.                                                                                                    

Semiconductor companies are powering disruption across all industries

Need to create recommendation engines for everything from movies to restaurants to clothing, or crank up machine learning systems to remove spam from millions of inboxes? Find the quickest way home? Play a game in smooth 4K? Conjure the metaverse itself?

Electric cars? These cannot run without power semiconductors from ON Semiconductor and Infineon. Ditto the home solar roof panels which require inverters and rectifiers to turn the DC current to AC, on which almost all appliances run. Even excluding battery electric vehicles, the silicon content of cars is set to triple in the next three years as drivers demand better safety features such as lane departure and school zone warnings, not to mention ever more sophisticated in-car displays and entertainment/navigation systems.

Indeed, the reason that used car prices have skyrocketed is because new cars are not available pending the required chips to finish them. Semiconductors are now critical in areas as diverse as shipping logistics, vaccine development and power grid management.

The Loftus Peak portfolio does not include semiconductor companies because it is a technology investor, trying to pick winners from a commoditised group of companies making low value-add components for computers. They are there because of their critical role in powering the cutting edge of disruptive businesses in all parts of the economy.

Where next for semiconductors?

The revenue limitations for semiconductor companies are not related to demand, but supply. Because of supply chain mayhem caused by COVID-19 coupled with an endless thirst for compute cycles required by advanced applications, there is simply not enough capacity in the world's major chipmakers to satisfy the demand. It's the reason that TSMC has allocated US$100b over the next three years to additional manufacturing capacity, more than double the normal sum. Virtually the entire company's production in 2022 is already sold, and the situation seems likely to continue into 2023.

The Economist magazine recently referred to data as the new oil - true enough - and it is the semiconductors that are producing, storing and generating value from it. There is no sensible reason for any fully engaged market participant to miss this trend. Investors should look to their own portfolios to ensure adequate, well-priced exposure.

Efficiently adapting an integrated ESG investment process to new information inputs is essential for investors. Richer information helps us identify hidden risks in company operations and focus our engagement on weak actors. In 2021, we enhanced our in-house ESG scorecards with carbon emissions and modern slavery information and learnt a few things along the way. AGM voting season prompted us to wonder if some companies deserve a meme song: If you don't spill me baby I'll do anything I want.

One of the persistent aspects of investing over the long term is that information inputs morph in response to corporate trends and regulatory reporting requirements. Investment processes need to adapt to this new information when it's relevant to investment decisions.  With this in mind, Longwave was founded with the intention of always keeping an eye on the horizon and adapting to new information inputs. Our core investment philosophy never changes (that Quality small cap companies outperform over the long term).  But we recognise that if we can systematically capture new information early, it may enrich or enhance our decision making on the fundamental side of our investment process.

This need to adapt to new information is most obvious at the nexus of an integrated ESG approach.  At the beginning of 2021 we observed the following changes in the ESG information landscape: carbon emissions data had significantly improved for small caps; companies have started to report their Modern Slavery approach and Sustainable Development Goals have started to turn up in company annual report commentary.

At Longwave, our fundamental stock valuations are directly impacted by ESG scores. As more information becomes available, our research management tooling has enabled us to bring in new data and adapt our scorecards as the information landscape morphs.

With this in mind, we set out at the beginning of 2021 to enhance our ESG scorecards with information on Carbon Emissions, Modern Slavery statements and SGD's. We love learning new things about companies and this ESG enhancement is no exception. In this report we share what we set out to do and what we learned and a few thoughts about how we think the information needs of ESG focused investors are likely to change in the next couple of years.

Carbon

We've believed for many years that the early 2020's would eventually be the turning point in the markets' focus and understanding of the gargantuan global task that climate change transition represents. One of our ESG goals for 2021 was to be able to measure Scope 1 and 2 emissions reliably and accurately across our portfolio. Up until this year, accurate GHG emissions data for small-cap companies has been hard to come by and very few companies have been reporting emissions.

Our analytical needs are multiple and sit at both the portfolio and company level. We need to be able to:

• Compare company emissions relative to peers,
• Have a starting point from which to measure company improvements (evidence that a company is making changes to their operations),
• View our portfolio Weighted Average Carbon Intensity (WACI) so that we can measure concrete change in our portfolios and,
• Price carbon risk at the company and portfolio level.

This year a dataset with reported and relatively high confidence estimates became available for the small-cap universe. We incorporated it into our research management platform and using that as a base, have cross-checked it against reported information and started a conversation with some of the larger companies in the small-cap universe who appear to be outliers.  As always with data projects, we learnt a few things during the process:

• Disclosure in small caps is problematic relative to large caps
• Estimates provide a way of improving coverage but can still vary wildly from the actual disclosure.  Data that doesn't fit with our understanding of the business model has prompted us to engage with specific outlier companies.
• There's a wide divergence across small companies in both their GHG emissions and the strategies management are employing to report and improve them.

We are now able to see (at the click of a button) the Weighed Average Carbon intensity of our portfolio vs the index both at the aggregate, sector and company level. We were pleased to see that the portfolio carbon intensity is lower than the index without having expressly controlled for emissions.

Source: Longwave Capital Partners, Company Reports, Bloomberg Estimates. 98% of the portfolio has either reported or estimated data as at 31 Dec 2021

We are also able to track changes in intensity through time.

Finally, we used this as an opportunity to think about how the data might be used to reward companies that are making a genuine difference to climate change transition. If we think from first principals about what has to change between 2020 and 2050, companies with emissions intensive operations will need to invest in their asset bases (probably out-of-cycle) to lower their emissions intensity. The role financial markets play in that equation is to both provide the capital necessary for the transition and to reward the improvers with a lower cost of capital. Alongside a transition of the existing asset base, financial markets have a role to play in funding new technology solutions in a range of energy market and industrial equipment verticals.

When we look at the Australian small cap universe, the companies with the lowest emissions intensity tend to be in that position naturally (due to business model or industry). As a result, they are unlikely to ever have a significant role to play in moving the economy further towards net-zero. Holding a portfolio of these carbon-light businesses might feel good, but in practical terms, your incremental capital investment (reinvested profit sitting inside each company you own) isn't actually being spent on the effort to transition to net-zero.

On the other hand, some of the more emissions intensive businesses (such as Viva Energy) have a significant role to play in transitioning their asset base to net-zero and in the absence of government policy can choose to invest or not invest. We think companies who have higher emissions intensity but show big improvements year on year because they're investing incremental capital to facilitate transition should be rewarded for their efforts. And we think investors who truly want to ensure their money is contributing to transition in the most impactful way should be thinking about how their captive incremental dollar of capital spend is being put to work.

Over 2022 and beyond we will use our new dataset to explore these ideas further.

Modern Slavery

In 2018 the Australian Government passed the Modern Slavery act.  Any business with revenues over $100m is required to prepare a modern slavery report that outlines risk of exposure to modern slavery in the operations and supply chains of the company. These reports are supplied to the Australian Government and are generally made public on company websites.  Our objective in incorporating Modern Slavery into our Social scorecard in 2021 was to analyse the statements produced by our portfolio holding companies and understand how each company identifies and manages the risks. Modern Slavery is what we think of as a slow-burn hidden reputational risk. A public exposure of particularly bad corporate actors has the potential to lead to large customer boycotts, fines or the need to re-point a global supply chain to higher cost suppliers. A better understanding of just how focused a company might be on these hidden risks can help us avoid or weight the portfolio away from companies with higher exposure.

We are now able to see at the portfolio level, what percentage of our portfolio isn't reporting on modern slavery. We will use this to guide some of our ESG engagement in 2022.

Source: Longwave Capital Partners, Company Reports. 75% of the portfolio has been surveyed at 31 Dec 2021

We are also able to see the categorisation of our portfolio (and each company) into high, low and unknown risk. Again, this will help us form targeted engagement in 2022.

Source: Longwave Capital Partners, Company Reports. 75% of the portfolio has been surveyed at 31 Dec 2021

This process was rich with learning outcomes:

• There was a wide range in the quality of reports. Some companies had gone to serious lengths to think about where hidden modern slavery might occur in their domestic supply chain and were already implementing targeted staff training so that everyone in their operations was equipped to spot the signs. Others were simply implementing a layer of relatively weak legal protections (supplier contracts) and didn't appear to be methodically working through the best way to actually help eradicate the practice.
• Across the board, risk mitigation strategies tended to take the form of contractually requiring offshore suppliers to simply sign a statement that they complied with the Australian legislation. Best-practice risk mitigation appears to be using a respected global NGO to zero in on at-risk countries and industries and then contracting those NGO's to do spot checks.
• We identified one company in the 'software AI' space that wasn't producing a modern slavery statement despite our knowledge of the operations suggesting their supply chain is very likely to contain high risks.

We will use these learnings to further enhance our qualitative data capture on modern slavery over 2022.

Proxy Voting Observations

And finally to Poker. We are often blown away by the greed which can be on show in the annual ritual of renumeration reports and votes. Philosophically, we believe that its fine for management to be paid for performance, but our active voting policy clearly spells out that we need to see appropriate and transparent hurdles.

What's unique about Australia is that shareholders have the 2-strikes and a board spill tool at their disposal (if greed morphs into avarice). Nine companies in our systematic portfolio this year had board-spill motions put to shareholders. But within that 9, three stood out and prompted a discussion of what we term board-spill poker. Board-spill poker is when a board decide (after a first strike), to make either minor or no changes to the renumeration structure and put it back to shareholders. We can only assume they are intending to call the bluff of the shareholder base (most likely under pressure from founder managers). The remuneration report votes are advisory only, so if shareholders are unwilling to use the consequence option as it was intended, it's a toothless tool.  In the absence of material personal consequences for being 'bad actors', the renumeration practices can continue unabated.

By way of example, a well known retail company received a 41% AGAINST vote to its renumeration report (second strike), but a full 95% of investors voted AGAINST the board-spill motion. We are happy to say that Longwave was in the 5% of investors who decided that a consequence tool needs to be used.

We will be interested to see the 2023 cycle of renumeration reports from these companies, but we wouldn't be surprised if there is no material change to their renumeration practices.

Some of the significant vote issues we dealt with over the primary AGM season included 3 board spills, 2 shareholder resolutions and a range of renumeration structures that didn't meet our standards.

A healthcare company we own continued to increase the CEO's base salary above inflation, despite having awarded an extremely large LTI package in 2019, followed by a 75% base salary increase in FY20 and large one-off retention bonuses. We had voted for the CEO LTI package two years ago, however we believe base salary increases continued to be excessive. We felt if didn't vote for a spill motion, the directors were unlikely to listen to a significant shareholder issue.

A resources company we own put the same renumeration framework to shareholders 2 years in a row after a 93% vote against the Rem report in 2020.  The board spill was an easy decision to make; there had been no change to the company's remuneration framework compared to the prior years and it really did solidify our concerns about board independence.  We subsequently voted for board candidates (a mix of independent and major shareholder aligned) who we think will better align the renumeration structures to the economic interests of shareholders.

Another resources company we own had a shareholder resolution put up that would have required the company to disclose, in subsequent annual reporting, a plan that demonstrates how the company's capital expenditure and operations for its coal assets will be managed in a manner consistent with a scenario in which global energy emissions reach net zero by 2050. We voted FOR this resolution as we believe that improved understanding of financial scenarios for capital allocation and cash flows back to shareholders under a net zero by 2050 scenario would be useful. It prompted us to think about a world in which coal asset-owners publicly publish their responsible shutdown plans matched to transition and how that might impact pricing of the equity. Unfortunately, the resolution was defeated.

Finally, a founder-led telecommunications business we own sought to issue options to non-executive and executive directors because of the dilution they had suffered after successive capital-raises to fund the company's acquisitive growth strategy.  The board of this company is non-independent. Executives and NED's are adequately cash compensated, and Executives also have in place adequate STI and LTI structures. We voted against this options issuance as we didn't believe the options were appropriate for directors. Options create alignment differences with shareholders which may compromise independence. Additionally, the reason proposed was to counter equity dilution from new acquisitions directors suffer - however all shareholders suffer similar dilution with no options granted, and it is the value accretion from the transaction which is required to add value over and above this dilution.

Looking into 2022, as we increase our standards and engagement on environmental and social issues we may use director voting as a way of communicating a lack of action by boards on these matters.

Written By Melinda White, Equity Portfolio Manager