A Brief Look At The IPO Market
The first publicly traded companies, formed during the Roman Republic, were called Publicani. Their ownership was divided into ‘partes’ (shares), which were likely traded OTC in the Roman Forum. The first IPO that modern market participants would recognise was of the Dutch East India company in 1602 – as such it is regarded as the first publicly-traded company.
We’ve come a long way since then, developing a slick and almost universally-practiced procedure: private companies that would like access to wider pools of capital seek an adviser (usually an investment bank or a stockbroker) to lead the process and price the issue. Sometimes, for larger IPOs, this team then recommends other investment banks to take on a portion of the distribution and underwriting risk. The advisor will (where possible) act to stabilise the share price for a period after the IPO date.
The basic process that we all know and love is outlined below:
So far so familiar.
How do things look now?
Not good. It’s no secret that London’s IPO market has suffered recently: 25 companies have floated in London in the year to September 2019, vs. 87 in 2018 and 106 in 2017. The majority were new listings on the Main Market, with only 7 joining AIM. Only 4 IPOs took place in London (2 main market, 2 AIM) between July and September – the worst quarterly performance since 2009.
NEX Exchange has had little more success, with 8 new admissions year to date, out of a total of c.88 securities listed on it. This is in line with 2018, and both years were significantly ahead of any year prior to that. There will also be issuers with multiple issues, as NEX hosts some traded debt, some investment funds, etc. However, this growth in issuers over the last few years is in stark contrast with the more established exchanges.
The AIM market, incidentally, is more exposed than the main market to a dearth of new issues given that it naturally faces a relatively high issuer attrition rate through M&A activity, issuers moving to premium listings, and company failure/delisting. Since its zenith in 2007, the AIM market has not been able to arrest the decline in the number of issuers:
It’s worth noting, however, that this can be partially explained by an upwards trend in quality of AIM issuers, which has risen as this market has become increasingly strict on listing standards, moving closer to the requirements for a main listing.
The US IPO market is facing similar difficulties at present, particularly in pre-profit businesses like WeWork (office sub-letting), Endeavor (entertainment), and Peloton (fitness equipment). WeWork and Endeavor have both pulled their planned IPOs and Pelaton has only just re-approached its IPO price.
Elsewhere around the world the story is similar, with EY’s 3rd quarter IPO report finding that proceeds totalled $114.1bn from 768 deals, down YoY by 25% and 26% respectively.
Source: EY 3Q19 quarterly IPO report
So what’s the reason for this weakness? It could just be cyclical, as we’ve seen before. In 2008 and 2009 the number of IPOs in London dropped by 69.5% and 74.7% respectively. This cyclicality dwarfs any trends we’re currently seeing. It doesn’t feel that way this time though. The cyclical drop-off, being cyclical in nature, was accompanied by an economic maelstrom, the likes of which we’re certainly not experiencing today – though the protracted Brexit effort will surely be playing a part in weakening sentiment.
There’s another potential explanation for what’s happening: could the IPO process itself be a contributing factor?
A flawed process?
IPO investors tend to expect a jump in the share price on day one to reflect and reward the risk they have taken in investing prior to the entry into a public market. However, this very clearly signals that money has been left on the table – money that could have either gone into operations (in the case of newly created shares), or to the founders and VC investors, where they’re selling existing shares. As well as pricing to encourage for this expected 'pop' in the price, there is also the risk of inaccuracy/errors in a pricing system run by people who can make mistakes. Additionally, there can be misaligned incentives such as a drive to price the issue too low: If a bank prices the issue too high, it may slightly increase its fees but it will also increase the risk of failing to get the deal away and thus earning nothing.
Another risk to the bank of pricing the IPO too high is the impact on reputation if the price falls precipitously, making investors wary of its future IPOs. If it prices it too low it may miss out on some fees, but it’s guaranteed to get a large portion of the potential fees with minimal risk of failure. Thus the risk/reward for the bank is to price too low rather than too high.
Traditional IPOs are also long processes, and the time and energy they require can (i) distract management from operations, and (ii) risk the market or business changing over that time, potentially impacting the probability of a successful listing. This is particularly true in current, more volatile market conditions.
Cost may also be a concern. IPO fees can range from 2% to 8%, whereas the amount spent on intermediaries for publicity, etc. in a direct listing is much more under the control of the issuer. This can appeal to smaller or more cost-conscious businesses.
Finally, something more of moral concern is the exclusivity and informational asymmetry. In the IPO process retail investors and smaller institutions are often left out in the cold when it comes to book building. To put this disadvantage into perspective the average gain from all new listings to September 2019 was 22% but retail and small institutional investors would have only made a 4.8% average gain because they could only buy the shares on day 1 of trading, not at the issue price at which larger institutional investors could pick up shares. Informationally, only sell-side analysts linked to the banks involved in the process have open access to management ahead of the IPO.
A better way?
An increasingly common way of improving upon this experience, from the corporate’s perspective, is the addition of an independent IPO advisor such as STJ, Rothschild, or Lazard. These advisors help the company to decide on the members of the bank syndicate, aiming to deliver the broadest investor coverage. They also monitor the process continuously to generate a clear, data-driven view of investor reaction and positioning – improving the accuracy of pricing and the stability of early trading.
At the extreme, financial market participants are nothing if not innovative, so is it possible we could see the traditional IPO process replaced with something more streamlined? Many other markets have been ‘disrupted’ so there’s no reason to think IPOs are a special case.
In fact, Silicon Valley innovators are already starting to bypass the IPO process entirely, claiming they see little value in the traditional roadmap. Their preference? Direct Listings, also known as Direct Public Offerings (DPOs). These are as simple as they sound – computers transfer company shares to public markets according to complex algorithms, without involving intermediary banks to purchase large blocks of shares and re-distribute them to their clients.
This practice purports to speed up the process, cut costs, improve price discovery and avoid what many see as mis-pricing due to human error, or misaligned incentives.
Finally, retail investors can be deliberately included in a Direct Listing through use of crowd-funding platforms such as Primary Bid (we have no affiliation), which allows retail investors to participate in placings, including at IPO. This removes a source of inequity and potentially improves the reputation of the issuer. A key risk here is that this process may only work for companies with highly recognisable brands, or simple business models that retail investors can get interested in. There may also, in the early years of this concept, be a skew towards higher risk companies taking this route to avoid institutional levels of scrutiny.
Spotify ($27bn market cap) and Slack ($12bn market cap) both successfully took this route to market in New York in 2018.
Another contender for explaining the fall in the number of IPOs has nothing to do with the process itself: instead it could be the impact of the relatively low cost, and high availability, of private equity capital.
This theory is supported by the dwindling number of companies listed on London exchanges, which has nothing to do with how issuers list (IPO vs. DPO). AIM is currently host to a mere 52% (882) of the issues it was at its 2007 peak. On the main market there are currently 1,149 issuers, a mere 55% of the peak (2,075) 20 years ago in 1999 – or at least this is the peak according to the data available to me. Regardless, the point remains: there are roughly half the issuers in London that there were at the peak of the last 2 decades.
Over this period we have also seen a boom in private equity – PE funds have raised c.$5tn globally since 2012: so much that many funds are struggling to deploy their capital. Prequin, the financial data company, estimates that at the start of 2019 there was c.$2tn of dry powder across global PE funds. And demand for PE investments is also still growing relative to public markets: a Blackrock survey in 2018 asked 230 institutional investors (representing c.$7tn AUM) and found 51% were looking to cut exposure to public equities, and nearly the same amount looked to increase private market exposure. With this much private capital available and competing for investments, why would anything but the largest capital requirements lead to a public listing, with increased scrutiny, more shareholders, and increased regulation vs. private markets?
Whether the IPO process itself is part of the problem, or whether regulations, scrutiny, and the easy availability of private equity are the bigger factors, the level of UK public market listings is far from its peak. This is worrying given how much the global economy has grown since those peaks were achieved: we should be seeing fresh issuer highs but we’re not.
We’re unlikely to know whether this is cyclical or secular for several more years. For now all we can do is acknowledge that change may be coming, and to prepare for it by being aware of those companies quietly making their shares available on public exchanges, without the fanfare of the traditional IPO process.
Very loosely linked to this blog, we’re currently trying to understand how many of our investors look at the NEX Exchange. If you do, I’d love to hear from you – whether just to say “Yes, I look at companies listed on NEX” or whether to share your views on it.
Please also feel free to email me with any thoughts, ramblings, or blog topics you want to see covered.