What’s the Matter with the IPO Market? That’s the Wrong Question

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The initial public offering (IPO) market is undergoing fundamental changes as many IPO candidates remain private for longer periods than in the past. In this opinion piece, David Erickson looks at the reasons for this change, notably the huge new role being played by private equity. Erickson is a senior fellow in finance at Wharton and co-teaches “Strategic Equity Finance” with professor David Musto, chair of Wharton’s finance department. Prior to teaching at Wharton, Erickson worked on Wall Street for over 25 years, helping private and public companies raise equity strategically.

Over the course of my 25-plus years on Wall Street, I worked with a lot of companies on their initial public offerings. What was consistent over this period was that the IPO market would usually ebb and flow with the broader equity market and market volatility. When the equity market was performing well and volatility was low, the IPO market was typically very active. Today, things are different. We have almost daily record highs for the S&P 500 and the Nasdaq and volatility remains at historically low levels. Surprisingly, though, IPO activity is a fraction of what it has been in recent years.

According to data from Renaissance Capital, 2017 is on track to be the second least active IPO year in the last eight, lagging just 2016 (with 105 IPOs priced). So, after several articles (including this one) called for a revival of the IPO market in 2017, activity this year remains tepid with only 62 priced so far this year.

In the Strategic Equity Finance course at Wharton, we discuss why some companies go public and others stay private. Some of the reasons for each include:

Why Some Companies Go Public:

  • Raise equity capital – in some cases, large amounts or in sectors where private financing isn’t as prevalent.
  • Have a “public” acquisition currency – while private-to-private transactions occur, agreeing on value (as there is no publicly traded price for either company) can be challenging.
  • “Monetize” shareholders – including employees and investors/backers.
  • “Branding” the company – in addition to getting visibility in the media (i.e., CEO appears on CNBC, etc.), some companies’ customers and vendors can be more comfortable dealing with public companies, given the transparency of information.

Why Some Companies Stay Private:

So, what happens if a company can remain private, but achieve many of the benefits of going public?

What Has Changed in Recent Years?

About 18 months ago, I wrote a Knowledge@Wharton article about the “Unicorn” market where I argued that some successful companies were able to stay private longer because of two main catalysts. The first involved changes from the 2012 JOBS Act, which allows companies to have 2,000 shareholders (vs. the previous 500 shareholders) before having to start filing with the SEC. And second, more investment dollars were available in the private venture market.

While I had written about the increasing activity in the private venture market of prominent public market equity investors such as Blackrock, Fidelity and T. Rowe Price, I failed to note the increased buying power of private equity firms. According to Bain & Company’s Global Private Equity Report 2017, more than $2.3 trillion of “new money” has been raised by private equity firms (from buyout to venture capital to growth to mezzanine funds) in the last four years, and more than half a trillion in each of these years. The other thing to note about this new money raised is that it is unlevered equity – much of which, including most buyout and growth funds, can be levered to make investments. That is a lot of potential buying power.

“While accessing the vast pool of private capital is one path companies have pursued instead of going public, another path being rumored by prominent ‘unicorn’ Spotify is a direct listing.”

While not all of this money is focused on investing in private companies, more private equity firms in recent years have been actively investing in private companies across sectors, such as Ajax Health, Chobani, Cloudreach, SoFi, Tom’s, and Uber. Additionally, private companies have received financing to pursue strategic activities such as SilverLake increasing its investment in Dell to facilitate its recent acquisition of EMC. Previously, these private companies would likely have needed to go public to solve their financial or strategic needs.

This isn’t to say that these private companies will never go public, as their private equity backers will need to monetize at some point. However, with these alternative financing solutions, it may provide private companies with flexibility in the near-term, and if they are able and want to stay private.

In addition to an increase in investment dollars going into private companies, with the performance of the equity market since last year’s U.S. election, the strength of strategic M&A buyers has improved, and some have targeted companies preparing for an IPO. A recent example is Cisco’s January acquisition of AppDynamics the day before it was to price its IPO – at almost two times the value it was going public.

While accessing the vast pool of private capital is one path companies have pursued instead of going public, another path being rumored by prominent “unicorn” Spotify is a direct listing. In the last couple of months, several articles have noted the possibility that Spotify may avoid an IPO, and instead do a direct listing on an exchange. According to some of these articles, the rationale is that Spotify doesn’t need the money and instead wants to provide a mechanism for its shareholders to monetize.

As it is only rumored at this stage, it is unclear if the company’s reasons to go this route are to avoid the time and expenses of an IPO process (i.e., mostly, investment bank, lawyer, and accountant fees); and/or if it wants to do something unique like when Google did a “Dutch auction” for its IPO with the objective to optimize the IPO price. As when Google announced its intent to do a non-traditional IPO, Spotify’s potential path has sparked considerable interest.

“This lock-up is designed to create an orderly market for the shares as the stock ‘seasons.'”

Albert Wenger of Union Square Ventures, a prominent venture capitalist, tweeted when the Spotify articles first appeared, “Great to see, we are long overdue for some innovation in the IPO process.” However, a direct listing isn’t really a change in the IPO process (as there is no offering), but a listing of the company’s shares on an exchange. One of the biggest distinctions of a direct listing is normally all of a company’s shares are freely tradeable on day one, versus in an IPO where generally only the shares being offered – usually 10% to 20% of the company’s shares – are trading (with the rest often subject to a lock-up).

This lock-up is designed to create an orderly market for the shares as the stock “seasons.” The challenge of an IPO lock-up, however, is if there is tremendous demand for the IPO shares being offered, the stock can “pop” and trade up significantly. However, those that are locked-up are unable to sell until the lock-up is released (usually 180 days after the IPO pricing). In a direct listing, all shares, in theory, could be available for sale immediately, which can create a disorderly market early on as existing shareholders may sell individually (vs. coordinated as part of an Initial Public Offering). This can make the initial market for shares quite challenging as investors, who may want to buy a company’s shares, may be cautious in the initial stages, given this possible volatility.

Again, according to press reports, Spotify has supposedly engaged Goldman Sachs, Morgan Stanley, and Allen & Co. to presumably develop a strategy to create an orderly market for the shares. Hopefully, if Spotify goes down this path, it won’t have some of the regrets that some at Google had about its unique process. As Eric Schmidt, CEO of Google at the time of its IPO, explained in a 2010 article, “To this day I can’t fully explain why our stock price opened so high—causing the pop we had tried to avoid. A lot of complicated factors played a role.”

What Could Revive Interest in the IPO Market (Again)?

A few things:

  1. The private financing market cycles: As with all financing markets, this access to private capital will also likely cycle over time. When public equity markets get choppier, this tends to have an impact on the liquidity of the private financing market. That having been said, with large private equity firms such as Apollo, Blackstone, Carlyle and KKR going public themselves, their shareholders are looking for continued growth in AUM (assets under management) and corresponding fees to drive these stocks. As a result, these large private equity firms continue to raise new funds, and find creative ways to deploy capital longer-term like this recent Blackstone fund. In addition, publicly listed asset managers that have also invested in private companies, such as Alliance-Bernstein, Blackrock, Franklin, Janus and T Rowe Price, are also motivated to grow their AUM and fees. They will likely continue to invest more money in private companies.
  1. Alternative markets emerge: A few alternative markets have received investment and interest in recent years. Most notably is probably the Long Term Stock Exchange (LTSE), started by Eric Ries, the author of The Lean Startup, and backers including Marc Andreessen, Amy Butte (former CFO of the NYSE), and other Silicon Valley firms. As Ries wrote in his blog post announcing the LTSE, it is based on a phrase from his book: “What is needed is a new kind of stock exchange, designed to trade in the stocks of companies organized to sustain long-term thinking.” According to press reports, the LTSE is in discussions with the SEC to receive the appropriate regulatory approvals.
  1. The traditional IPO process evolves: While there have been significant technological changes in the trading of equities in the last 20-plus years, there have been limited changes in the IPO process. While Wall Street obviously has the expertise and capabilities to evolve, some of these changes need regulatory evolution as well.While there are many possibilities, one example, which is a big frustration to private companies and their backers, is the inefficiency of the SEC amendment filing process (S-1) during the IPO roadshow. In the case where a company has a significant amount of demand for its IPO offering (i.e., multiple times the offering size), the company may want to raise the IPO marketing range (greater than say 20%). If it does so, it needs to formally re-file publicly with the SEC, usually a day or two before pricing (so the SEC can do its review of the amendment, as well as investors).The challenge is, as this filing is public, in addition to the media reporting this positive news, investors realize the offering is well over-subscribed and likely to “pop,” meaning that the share price on the first day rises sharply above the IPO offer price. For the already over-subscribed IPO, this filing action well before pricing often causes investor interest and demand to increase even further, exacerbating the problem of excess demand and potentially “increasing the pop” in the after-market. As an alternative, if there could be a more efficient process with the SEC to file and review such amendments, this could give Wall Street more flexibility to optimally price these IPOs.

While an IPO is still the preferred path for many large companies, as well as others that have unique financing needs, in the coming years it will be interesting to see the trends of the number of companies going public and the volume of capital they are able to raise. With alternative paths evolving and taking away potential interest for companies to do IPOs, maybe the IPO process may evolve too – which would be a good thing.

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