Going public, igniting the phoenix

2023 has proven to be a challenging year for initial public offerings (IPOs). Volumes have plummeted, and the few IPOs to complete are floundering in the aftermarket. Investors continue to grapple with hefty losses from the IPOs of 2020 and 2021. Moreover, private equity firms have resorted to buying back companies they had floated only a couple of years earlier, putting them out of their misery after sustained underperformance in the share price.
The European landscape paints an even bleaker picture. Several blockbuster IPOs failed to materalise, as issuers chose to bide their time for more favourable market conditions. Other stock market debuts of companies were postponed after investor roadshows had completed.

In short, it’s really tough. If good companies are finding it difficult to list, is it time to write the obituary for the IPO as a financial product?

My answer is emphatically “no”. The IPO market is open but it is not indiscriminate. And right now companies and selling shareholders are locked in a standoff with investors because they’re playing in different valuation sandboxes. But fear not, this impasse will get resolved, and the market will rise phoenix-like from the ashes. It will just take some time.

It is worth examining briefly why there is such a disconnect between the two sides of an IPO. Many companies raised huge amounts of capital at frothy valuations during the COVlD-era boom of 2020 and 2021. Valuations for tech and so-called “concept” stocks have corrected sharply since then, but attempting an IPO on a “down round” — ie list n at a valuation below the previous round of financing — is a hard sell.

For one thing, it requires the private investor to mark down its holding, exposing them tovredemptions and recriminations from their end-investors. For another thing a, “down round” often triggers anti-dilution provisions for incumbent shareholders, creating tensions with other shareholders such as long-serving employees and top-level managers. Ideally, most companies would prefer to wait for the market to rebound and launch an IPO at a level above the last financing rounds.

For investors it’s a different story. They piled into IPOs and SPACs in the frenzied period of 2020-202, and their portfolios bear the financial scars even today. In today’s markets they are showing more discipline, flexing their muscles, and wielding pricing power, demanding that some money be left on the table when pricing an IPO. Public equity investors are fighting for every inch of performance against a backdrop of twitchy limited partners (ie end-investors) prepared to yank their money out at the first sign of underperformance.

However, the discounts demanded by investors are proving intolerable for companies and their owners, partly because many of these IPOs involve selldowns rather than raising new capital to fund growth and investment. A lower sale price translates into diminished returns for venture capital or private equity firms, potentially even falling short of the required hurdle rate.

So what kind of IPOs can get done? First, the bigger the better. Investors have been frustrated by low market liquidity, making it difficult for them to adjust their position size. Even if a stock has an attractive price, no investor wants to buy, say, €25 million in an IPO, only for the average daily trading volume to fall to €1 million per day. No investor wants to be trapped in this way, and in any case, the risk managers at the fund management firms will stop the portfolio managers from holding these kinds of positions. So, to quote the 1998 Godzilla film, “size does matter.”

Second, spinoff IPOs out of industrial conglomerates will be attractive. Investors will be familiar with the asset, and the parent companies are often less fussed about squeezing every cent in the IPO pricing. Investors have very fond memories of the Porsche IPO out of Volkswagen, even if other spinoffs, such as the Nucera IPO out of ThyssenKrupp, have faded in the aftermarket after a positive debut.

Third, quality is paramount. The “dash for trash” mentality of 2020-2021 is over. Investors now seek sustainable growth, strong cash generation and robust margins. If an IPO-bound company is losing money, it had better have a credible path to near-term profitability.

In short, I’m optimistic that volumes will recover in 2024 after two years of sluggish activity. But the valuation bottleneck will first need to be cleared.

Craig Coben.

Former Global Head of Equity Capital Markets at Bank of America and contributor to the Financial Times