To the untrained eye, the IPO market looks calm. But there are three hidden pressures building up in the new-issues market, says Taipan Daily editor Justice Litle in conversation with hedge fund manager Cash McDash (a pseudonym, of course)…

JL: Hey, long time no chat. It’s been a few weeks since we last caught up in Taipan Daily.

CASH: Yep, happy to be back. It was great hanging out and meeting readers at the Global Opportunities Summit in San Francisco, too — even though one or two of ‘em tried to take my picture. Heh.

JL: Speaking of the San Francisco conference, you brought up a topic there well worthy of further discussion. I was hoping we could touch on that today.

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CASH: Sure. We covered a lot of profitable ground at that conference… Which topic, specifically?

JL: Remember the extended panel session on the final day, where we all talked a little bit about anything and everything? One of the things you mentioned was a “growing pressure in the system” that could result in an explosion of profitable new deals. There were some interesting dynamics there. Can you expand on that a bit?

CASH: Sure. I think the analogy that I used was a garden hose connected to a spigot with no pressure control.

JL: Right. You told a story at the conference about your dad warning you not to use a certain faucet in the yard when you were a kid. But you used it anyway, and the result was a big wet explosion (and a very mad dad).

CASH: Good memory. Yeah that’s the idea. If the nozzle is closed and water pressure builds up in the hose, things look very still and calm from the outside. But on the inside, the pressure continues to rise and rise. That can only happen for so long until something bursts.

JL: So that’s your working analogy for the hidden pressures building up in the new-issues market.

CASH: Yep. You can’t see it without observing closely, but there are two primary forces that will drive this explosion in new issues. The first is growth pressure — a dire need for investment capital. The second is private equity pressure — a need for Wall Street players to book profits on deals.

JL: Can you give more detail on these two “pressure forces”?

CASH: Sure. The first one, growth pressure, is all about small companies needing to fund growth expansion or repair a damaged balance sheet. A weak economy accentuates this. Many firms are seeing lower revenues than they expected. This means they have less working capital to expand factories, beef up the sales force, expand research and development and so on. Without investment capital, small growth companies have a hard time sustaining growth — and that’s what small caps are all about. Many of these companies will need new capital to survive, let alone thrive.

JL: So when it comes down to it, many of these guys will have to come to market as a matter of life and death. And what about the second of the two forces, private equity pressure?

CASH: That’s all about the private equity companies that own many of the companies just mentioned. When a new issue comes to market, many times it’s an exit from a private equity player’s portfolio. Selling shares to the public, in part or in full, is how private equity guys (and gals) get paid. These players can be behemoths like Blackstone or KKR or Fortress Investment Group, or they can be more low-key outfits you’ve never heard of. But the uniting factor is that all these private equity players are sitting on privately held investments that must be released to the public eventually. They’ve been holding a lot of deals back because of rough market conditions — but the pressure to book profits is building, and they won’t be able to hold back much longer.

JL: OK, that makes sense. So the sellers have a vested interest in getting stock out the door and sold to the public. They’ve had their hands tied because the market has been so rough. And now the pressure is rising. But if I recall correctly, you brought up some other points at the conference, too. Is there another piece of the puzzle here?

CASH: Yes there is. Once again, good memory. The other side of the coin is the underwriting picture. My boys at Morgan Stanley(JPM), Lehman Brothers (LEH) and Merrill Lynch (MER) are hating life right now.

JL: I can imagine morale is a bit low, at Lehman and Merrill especially. Lehman keeps getting whacked for billions, and Merrill has come out with cap in hand so many times it’s starting to be a running joke. It’s like an old Britney Spears video: “Oops, I did it again.”

CASH: You ain’t kidding! Times are tough. These are shops where even the secretaries are used to getting six-figure bonuses. Good earners get company perks like all-expenses-paid trips to the Caribbean — or at least, they used to — and the really big earners used to have monthly expense accounts that rival normal folks’ annual salary. But all that has changed in 2008, as the music stopped playing and it turned out there weren’t any chairs left. Extravagant lifestyles are being cut way, way back. Some guys are just hoping for a bonus big enough to cover their mortgage on the second house in the Hamptons.

JL: There’s a tear in my beer. Excuse me while I dab my eyes with a tissue… What’s the connection between investment banks’ pain and building pressure in the new-issues garden hose?

CASH: It’s pretty simple really. Just follow the money. These investment houses are dying to get deals done. Their balance sheets are in as rocky a shape as the small companies that need cash and the private equity players needing to cash out. They need the lucrative fees from issuing IPOs in a bad way — and they need those fees right now. Not tomorrow, but today. Heck, they need those fees yesterday.

JL: So there are really three big-pressure angles. Everybody needs those dollars… and that means the deals will start rolling, come hell or high water, and waiting for a window of opportunity matters less and less as the clock runs out and the stakes rise.

CASH: Yep, well put. You can bet that as we start to see any glimmer of hope that the market is stabilizing they will push every deal with a pulse and try to get it trading. Investors will get pitched up one side and down the other as to how great all these companies are and how clients should be backing up the truck on every deal.

JL: Something tells me these deals won’t all be home runs. They’ll be bringing out a lot of mangy dogs and trying to pass ‘em off as best in show.

CASH: You’re right about that, my friend. One thing we’ll have for sure is what we traders call a “target-rich environment.” As we’ve talked about before, some of the most important tells about how a stock will trade are the events leading up to and through the actual offering. We could see dozens of names that simply don’t have any business being public companies. But they’ll get pushed out anyways, because all parties are desperate and the underwriters value fees more than reputation at this point.

JL: And their desperation becomes our opportunity, right? You’ve said before that shorting busted IPOs can be like shooting fish in a barrel when the conditions are right.

CASH: Yeah, except traders don’t get paid to shoot fish — but they can make millions shorting dud IPOs. Just like Verso Paper (VRS:NYSE) — remember that one? — became a deathtrap for investors, dropping from $12 to $5 in less than three months. We could see more opportunity to short IPOs in the next four months than we’ve seen all year thus far.

JL: Yowza. That’s a pretty bold prediction. Verso does show the potential, though, along with other short calls you made — like the one on VMware (VMW:NYSE). We beat the drum on that one, and I know some of our readers absolutely cleaned up on it. I imagine our readers would want you to back up your opinions with a bit more than gut instinct.

CASH: On the bold prediction side, it’s not just a gut-level hunch of mine; we’re seeing the data bear this out. The second quarter of 2008, for example, saw more companies file to go public than we have seen in the previous two.

JL: But I thought the second quarter was a lot slower than normal as far as IPOs go.

CASH: Exactly! We saw more companies file, but not actually pull the trigger yet. That means they’re waiting in the wings. So not many companies have actually completed the process…

JL: And thus the pressure is building. Your garden hose analogy again.

CASH: You got it. There are some high-profile names in this pipeline, like KKR, the private equity company that rivals Blackstone. But there are also lots of smaller, less well-known start-ups. Word on the Street is that the fourth quarter could be the strongest this year in terms of actual new issues. That confirms what I’m saying about the target-rich environment we’re anticipating.

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JL: And mixed in with the dogs, it sounds like there are still a few select candidates that could run for tremendous longside gains, too. Plenty of “duds” to play on the short side, with a few home run buying opportunities for good measure.

CASH: Right, both ways as always — shucking and jiving, as you like to say. The best kind of diversification in a crazy market like this is to have opportunity on both the long and short sides. In the next few months, we’ll have lots of both.

JL: And speaking of opportunity, the open positions in IPO Confidential are building now, and we’re starting to see follow-through. I’m excited to see how those trades will play out.

CASH: Me too. It can take a little time for new positions to get rolling sometimes, but patience pays off. We could be ringing that cash register in a big way very soon.

JL: No pun intended, of course. As always, great catching up… We’ll have to do the conferences more often, too, so readers can see and hear the elusive Cash in person.

CASH: Sounds like a plan.

P.S. Read on here for Justice’s introduction to Cash McDash.

Source: Why the IPO Market Could Be Set to Explode