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Picture of Christopher A. Hopkins, CFA

Christopher A. Hopkins, CFA

Is the IPO market thawing?

Two high profile public offerings are fueling optimism that the moribund IPO market is thawing following last year’s deep freeze. The public launches of chip maker ARM Holdings and grocery service Instacart were greeted enthusiastically amidst a dearth of new listings over the past couple of years.

The market for initial public offerings or IPOs was red hot in 2021, setting a record for new issues valued at $156 billion, but plummeted by 95% in 2022 to just $9 billion in volume and has remained relatively weak this year. A robust IPO market is crucial to economic growth in a market economy as a source of risk capital for growing companies and to maintain the supply of publicly traded stocks as a destination for trillions of dollars in pension and 401(k) plans. Yet the structure of the marketplace has evolved, regulatory hurdles have made IPOs less attractive, and cyclical headwinds are still present that may dampen enthusiasm in the near term. And while new IPOs are crucial in the aggregate, they don’t treat individual investors who chase them with much respect.

Every stock that trades on an exchange was once a private company that decided to sell shares to the public. This sale of partial ownership to outside investors is called an initial public offering or IPO. This action allows the original holders like company founders, angel investors, venture capitalists, and other early-stage funders to cash in on their investments. It can also be an important source of funds to finance future growth.

Once the decision to go public has been made, the company must select an entity called an investment bank to handle the transaction and market the shares. JPMorgan Chase, Goldman Sachs and Morgan Stanley are three of the largest US investment banks, but hundreds more exist that specialize in small- or middle-market companies.

The investment bank files a registration statement with the SEC that includes financial statements, management bios, proposed use of the funds, and disclosure of any relevant legal issues. Approval by the SEC does not constitute an endorsement but certifies that all legal requirements have been met.

Next, an IPO date is set, and the selling process begins. A summary document known as a preliminary prospectus (Latin for outlook or view) is filed with the SEC and disseminated to potential buyers. This preliminary document contains all relevant financial, management and legal information but no price or issue size. Because it is printed with a red stripe or on pink paper, it is often referred to as a “red herring”.

The investment bank partners with other banks in a a collaboration known as a syndicate to spread the risk and increase distribution. The bankers and company management then visit institutional and high net worth investors in a so-called road show, building a book of potential orders for the shares.

Immediately before the IPO date, a final prospectus including the offering price is filed with the SEC. On the date of the offering, the investment banks begin selling the shares to institutions and individuals who expressed interest at the specified price. At this point, the company is considered to be public, and investors commence trading shares on the stock exchange in what is called the secondary market at the market price determined by supply and demand.

A strong pipeline of IPOs is essential to restock a dwindling supply of publicly traded firms. Access to cheap capital, burdensome regulations, and a growing interest in private equity investments from large institutions has dramatically culled the herd of public companies. Today, there are half as many public companies as there were in 1996 with a total market value 5 times larger in today’s dollars. This has contributed to the excessive concentration of market capitalization in a handful of mega cap behemoths.

Yet while a steady supply of new issues is essential for the overall economy, IPOs have not typically been good investments for individuals trying to get in on the fun, especially on the first day. It is important to recall that an IPO is the payday for the company’s founders and a select group of private venture and angel investors for whom the listing presents an opportunity to cash in. Individual retail investors by and large are unable to purchase shares at the IPO price and often succumb to the opening day fervor, overpaying for the shares once they begin trading.

According to NASDAQ, the average opening day “pop” in new shares is 18.4% above the IPO price due to an excess of demand over supply. However, that premium usually evaporates. Around two thirds of new issues underperform the overall market over 3 years, with 64% falling more that 10% below the market return. Tech-oriented companies, perhaps unsurprisingly, have experienced the greatest opening day pops. (Aside: buy low and sell high still obtains. This is not it.)

This relative underperformance of new issues owes partly to the popular hype around IPOs and partly to the composition of companies coming to market. Between 1980 and 2020, 80% of all new IPOs involved money-losing firms.

A recovery of the IPO market with profitable companies at reasonable valuations would be a welcome development for the economy, for broad equity markets in general, and for investors in the aggregate. Chasing a hot IPO, on the other hand, is likely to impart a hard lesson in speculation with a high tuition cost.

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