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Published 19 May 2012 00:06, Updated 19 May 2012 02:36
Illustration: Karl Hilzinger
Most companies knock loudly on the sharemarket’s front door on listing. They spruik their float to brokers and the media and hope investors will welcome them with open arms. Others list by sneaking through the back door with reverse takeovers or mergers. Some of them soar.
These backdoor listings are poorly researched and understood, despite hundreds of companies using them in the past decade and signs the sharemarket is on the cusp of another wave of reverse takeovers as the float market struggles and more listed companies fail.
There were 26 backdoor listings in 2011 and eight in the first quarter of 2012, Australian Securities Exchange data shows. This compares with a peak of 32 in 2000 as dotcom companies did reverse takeovers of listed explorers, shows research by Dr Peter Lam of UTS Business School.
Backdoor-listed companies use the carcass of a struggling listed entity. They are an important part of the sharemarket food chain: one company raises capital, lists and almost dies; another picks up the pieces and injects new life into the listed shell. This form of “creative destruction” – where stronger companies prey on the weak – can create huge gains and losses.
Unlike initial public offerings (IPOs), backdoor listings usually have little fanfare. Large brokers seldom promote them and there is no central information source that tracks recent and upcoming backdoor listings or analyses their aggregate performance. Most slip below the radar of fund managers, big sharebroking firms and the media, thus creating opportunity for eagle-eyed speculators.
Such listings are typically between small listed companies and private businesses. The listed shell company buys the private business or its assets and in exchange issues vendors with shares and/or cash. The deal usually changes the company’s operations and ownership, leads to new management and directors, and dilutes the shell company’s current shareholders. Capital is often raised through a placement accompanying the listing, and a prospectus and independent expert’s report is issued.
Even though the listed company keeps its name, or later changes it, the backdoor listing, in effect, creates a new entity. ASX Listing Rules require companies to seek shareholder approval for backdoor listings and re-comply with exchange admission requirements, to protect investors. The rules are broadly the same if the company uses the market’s front or back door.
Most backdoor listings involve micro-cap companies. For example, a junior gold explorer raises $5 million through an IPO and a few years later has $500,000 in cash left after exploration results show it has a lame project. Another explorer decides it is easier, faster and cheaper to arrange a reverse takeover of the struggling gold explorer than listing through an IPO in a difficult market.
Some listings have a higher profile. Yellow Brick Road Holdings, run by executive chairman Mark Bouris, backdoor listed last year through the migration business, Interstaff Recruitment, a failed $5 million IPO in 2007.
Yellow Brick Road’s shares, now 26¢, have struggled since official readmission in June 2011, in a tough market for wealth management stocks.
Coal explorer ZYL was another prominent 2011 backdoor listing. It used the shell of Perth technology company ZYL and raised $30 million. The South Africa-focused explorer has a 316 million tonne, high-ranking coal resource that complies with the Joint Ore Reserve Committee Code, and counts Macquarie Group as a substantial shareholder. ZYL shares have fallen from a 52-week high of 27¢ to 14¢.
Some smaller backdoor listings have done better. Red Emperor Resources shares rallied from 20¢ in late 2011 to 76¢ in March, amid promising exploration news at its Puntland oil project in Somalia. Its shares are 44¢. And Black Mountain Resources rallied from 22¢ earlier this year to 32¢. It has had good results at its New Departure silver and gold project in Montana, US.
Strong, sustained growth from backdoor listings is, however, the exception. They collectively underperform the sharemarket and comparable IPOs over long periods, says Lam, who has studied such listings extensively. His PhD thesis, submitted in 2010, analysed 200 backdoor listings on the ASX between 1999 and 2007.
It provided rare insight on Australian reverse listings.
Lam found that over three years from their reinstatement to the ASX, backdoor listings underperformed the S&P/ASX 200 Index by 62 per cent on average and IPOs in similar industries by 37 per cent. “backdoor listings are generally very risky investments,” he says. “Against several measures, their aggregate performance in Australia has been poor.”
Care is needed with comparisons between backdoor listings and other listed companies. For one thing, backdoor listings are sometimes hard to define, and a lack of easily accessible information on them compared with IPOs can make analysis challenging. Also, capital reconstructions and capital raisings can skew early percentage gains or losses for their share prices. By their nature, backdoor listings often involve speculative companies that have much higher risk and rewards.
Lam found that shell companies often provided much stronger share price gains during takeover. On average, vendors paid a “shell premium” of 40 per cent for their reverse takeovers, or the equivalent of $1 million (in 2007 dollar terms).
Simply put, the share price of the dormant listed company spiked as the market speculated on a takeover, or as news was announced. Buying into the shell company before its takeover was a better strategy than buying it after the listing. Some backdoor listings, however, create excessive dilution for existing shareholders when new shares are issued and gains are eroded.
“Current shareholders in the company, on average, gained much more from backdoor listings than those who bought in after the company was reinstated to the ASX, or during its placement,” Lam says.
Such gains may mean little to shareholders who invest in IPOs then watch them sink from 20¢ to 2¢, and then sit on almost worthless stock in a company that may be in administration. But speculators who identify potential backdoor listing candidates, and time their investment well, can enjoy windfall gains via takeover. Of course, they take great risk investing in companies that have little more than a listed shell, or are suspended or in administration, and have much more baggage than newly formed listed companies through IPOs.
Lam’s research identified common characteristics in successful backdoor listings. Larger ones tend to perform better than smaller ones, presumably because more substantial assets are vended into the listed shell.
Backdoor listings accompanied by capital raisings also did better; a private placement to sophisticated investors may suggest that “smart money” is backing the deal.
Timing is also important. Lam found backdoor listings during the dotcom bubble in 1999 and 2000 did poorly over the long term, which is no surprise given many emerging technology companies then had vastly inflated valuations. In time, the same trend might be true of resources companies that list now through reverse takeovers, given the mining investment boom.
A back-door listing’s early performance also provides important clues. Lam found those that spiked higher on news of a reverse takeover did better in the long run. A bigger shell premium suggested the market had a more favourable view of the new management or the assets vended into the shell.
Lam’s research suggests there may be significant opportunity for speculators who invest in backdoor listing candidates before the market speculates on a reverse takeover, or news is announced. But not all shell companies fit the bill: some have complicated ownership, ongoing litigation, legacy assets, entrenched boards, cranky shareholders, little or no cash and are in administration. Their failure may have badly damaged the brand, and sentiment towards the stock could be abysmal.
Even so, recent trends suggest there may be many more backdoor listings in the next few years. They tend to clump in weak markets, and there are usually more during weak IPO markets, and vice versa. Dotcom companies active in backdoor listings in 2000 were replaced by life-science companies a few years later, then mining companies in the past few years. As one sector wilts, another springs to life.
Much depends on how many listed companies struggle or fail. By volume, junior explorers have dominated the 570 IPOs since 2007; last year they accounted for more than 80 per cent of all floats. But seven in 10 IPOs in 2011 sank below their issue price, and the median capital raised was just $5 million – barely enough to fund a decent two-year exploration program.
If this trend continues, dozens of underperforming explorers that raised less capital than they wanted will have to conduct their next capital raising sooner than expected. Without fresh funds, they will die. Further deterioration in sentiment towards smaller resources stocks could lead to dozens of explorers failing in the next few years – these will become the carcasses for the next batch of backdoor listings.
An increasingly difficult IPO market also suggests more backdoor listings. When the IPO market booms, more companies favour forming a new listed entity and raising funds. When it tanks, more companies favour backdoor listings.
Tough sharemarket conditions in 2011 meant 17 IPOs withdrew their listing applications, unable to raise their minimum subscription or secure enough investors to meet ASX Listing Rules.
Nine IPOs have been withdrawn this year. Many others have had to extend their offers by months, and issue supplementary or replacement prospectuses, before limping across the line.
Upon listing, there was little after-market support.
Back-door listings may seem easier than IPOs but Lam’s research found the average backdoor listing took longer to complete, and corporate advisers say backdoor listings often cost the same or more.
After-market support is another issue. In theory, backdoor listings should have more liquidity than comparable IPOs because they are established listed companies with a shareholder base. But some existing shareholders in backdoor listings are free to sell their shares at any time in the new entity. The vendors and promoters may have been issued shares that are escrowed.
In an IPO, the ASX deems some cheap shares held by seed investors, promoters, vendors or related parties to be restricted securities that cannot be sold for one or two years. This protects new investors in the IPO against seed investors who bought shares at, say, 5¢ in early funding rounds before the float, dumping them when the company lists at 20¢.
In a backdoor listing, an investor who bought shares in the original company at 20¢ and still owns them at 2¢ can sell at any time. As so often happens, existing shareholders sell when the price spikes after a reverse takeover, and cut their losses. Or they wait for higher prices and sell over the next few months, in turn creating an overhang of selling pressure that weighs on the stock. This is one reason so many backdoor listings struggle after official reinstatement to the ASX.
Investors who buy into the backdoor listing during or soon after its reinstatement to official quotation on the ASX, or through a capital raising, risk getting slaughtered by legacy shareholders who dump their stock. However, sometimes existing shareholders who believe in the company’s new management, ownership and strategy, hold their shares in anticipation of bigger gains.
“The big issue with backdoor listings is that they are effectively a marriage of convenience,” says Guy Aird, chief executive of Kennedy Needham Corporate Advisors.
“You usually have a struggling listed company that needs to do something new to restore shareholder value and a private company that wants to list without going through an IPO, or do a transaction that may not suit an IPO,” he says.
Aird has advised or participated in several backdoor listings in the past decade. He says vendors who think back-door listings are “quick and dirty” are mistaken.
“There can be issues with regulators, fights with existing shareholders and other skeletons in the closet if due diligence is poor,” he says. “They are seldom easy transactions for vendors, the shell company, or shareholders.”
The main attraction for vendors is the ability to do a transaction in stages. “In an IPO, the company has full or majority ownership of the asset on which the new company is based,” Aird says. “In a backdoor listing, the vendor might sell 40 per cent of the asset into the shell company, and secure an option for the remainder to be bought at a later time when the price is higher. This gives vendors much more flexibility; they don’t have to sell their asset when it is worth less.”
Backdoor listings can also provide a liquidity event for owners to exchange their illiquid ownership of a company for a proportion of cash and tradable securities, and Aird expects more private family-owned enterprises to use back-door listings in the next few years, as baby-boomer founders retire and look to exit their investment.
BlueMount Capital managing director, Len McDowall, advises companies to choose an IPO over a backdoor listing. “We don’t believe backdoor listings are necessarily cheaper, easier or faster than IPOs,” he says.
He has not only advised on several backdoor listings in the past 10 years, he has also written on the topic. “Companies essentially have to go through the same capital raising and listing process with a back-door listing as with an IPO, and they can be complicated transactions,” he says.
“Due diligence is a huge issue, the shareholder spread in the shell company is almost always insufficient to meet ASX listing rules, and the shell companies rarely have much cash,” he says.
“They can come with a lot of baggage if you don’t do your homework. There can also be issues with after-market support if existing shareholders sell their stock after the transaction.”
McDowall says backdoor listings are effective in some circumstances. “A company that is currently listed, rather than suspended, has some cash, and offers a synergistic fit with the vendor can make a good backdoor listing. For example, a struggling explorer with some cash on its balance sheet might merge with another explorer that has better assets. The backdoor listing is clean and in everyone’s interest.”
The evidence suggests such back-door listings are rare. More often than not, they erode shareholder wealth, although the same can be said of most IPOs in recent years. It is hard to make a case to buy unproven new listed companies, either through an IPO or backdoor listing, unless they have exceptional prospects, when established companies are generally trading on lower valuations in a bear market.
But from a speculator’s perspective, big gains can be made from backing the prey, rather than the predators, and taking quick profits. For investors, backdoor listings, like IPOs, are often best bought well after the event, when the selling pressure subsides and the door opens for better opportunity.