on December 11, 2019
Could Direct Listings Become the New Normal? Highly Likely
The NYSE recently filed with the Securities and Exchange Commission to change the rules so that private companies can simultaneously go public through a direct listing and raise new cash from public market investors. If approved this could be a significant step forward with direct listings becoming the norm rather than an exception for private companies to list on the public exchanges.
A major limiting factor in choosing a direct listing over a traditional IPO, as Spotify and Slack did most recently, has been the inability to raise new capital. The rule change proposed by the NYSE would allow a private company to list its securities on the Exchange as soon as its registration statement has been filed and approved. Currently when private companies choose a direct listing, they still must create and distribute a prospectus even though no new shares are issued; and only shares held by early stage investors and employees are sold to the public.
These proposed changes would allow private companies to take advantage of the benefits of a direct listing while also allowing them to raise new capital. The NYSE said in the filing that, “the proposed amendments would not impose any burden on competition, but would rather increase competition by providing new pathways for companies to access the public markets.”
Following the successful direct listings of Spotify and Slack, the groundswell of support from the executives of private companies, and the growing prominence of a vibrant secondary market we believe the proposed rule change will be well-received and move the needle forward toward making it the preferred path to public listing.
As the DL vs. IPO debate intensifies, consider the 3 inherent problems in the current IPO process:
1) private companies are not getting optimal pricing, frequently leaving “money on the table”
2) there is a conflict of interest since both the private company seeking an IPO and the investors buying into an IPO are considered clients (despite “Chinese Walls”)
3) too many players in a typical syndicate making the IPO process unnecessarily long, expensive and complex
Startups Not Getting Full Value After SubOptimal Pricing and Banker Fees
A study by Professor Jay Ritter of the University of Miami shows that during the period 1980 to 2018 roughly $165 billion was left on the table in a sample of 8,500 IPOs.
The aggregate amount could have been lot higher if ADRs and overallotment (Greenshoe option) of 15% entitled to IBs were also included in the list of IPOs and their respective proceeds. For instance, the 2014 ADR issue of Alibaba left an astounding $8.3 billion on the table, which is more than the total amount left on the table between the 10-year period of 1980 to 1989.
Another alarming trend revealed by the data is that the level of underpricing seems to be increasing. The last nine years have seen the average level of underpricing move towards the 15% mark. More importantly, instead of the IPO process getting more refined, streamlined, and transparent with time, the process has become more inefficient.
Findings from multiple empirical studies highlight the pricing anomalies in the current IPO process. This is all the more glaring since “pricing an IPO” is one aspect where the investment bankers claim to offer the most value. They claim their expertise is based on years of training in the field of private company valuation and finding a suitable price point for the company as per the demand amongst public investors. Their selling point is their ability to gauge demand by holding discussions with appropriate investors (both new and existing clients in their network) and influence supply by guiding companies on offering size and a price where supply matches demand (price that balances the needs of both existing shareholders and potential investors).
However, erratic and subjective pricing seen over the years suggests that bankers are increasingly finding it hard to maintain this very balance. The findings from the data highlight that faulty pricing can lead either to (1) underpricing, resulting in potentially meaningful losses to an issuing company and its investors or (2) overpricing, in which new investors are shortchanged.
Frequency Mismatch; Who is the Real Client?
The highly subjective and irrational nature of pricing an IPO suggests that either the valuation and pricing skills of the bankers have deteriorated over the years or there is vested interest at play leading to strong conflict of interest on the part of the bankers.
If this pricing irrationality / inefficiency was infrequent and limited to a small group of banks and bankers then you could attribute it to flaws in their valuation and pricing skills. Such is not the case. The pattern of mispricing permeates the industry.
At first glance, there are 2 plausible reasons an IPO might be underpriced:
• An IPO may be underpriced deliberately in order to boost demand and encourage investors to take a risk on a new company
• It may be underpriced accidentally because its underwriters underestimated the demand in the market for this company’s stock
Upon closer examination / scrutiny, however, other reasons become apparent. The question which must be posed is, who is the ultimate client?
Multiple Agency Problem
In a traditional / conventional IPO a bank or syndicate of banks is involved with multiple constituents: the founder or CEO who wants to take his / her company public and the group of buy side firms interested in investing in the new company.
This means that investment banks in a typical IPO setting have a dual role. On one hand they work with the company on managing the offering to raise capital at the highest price feasible while mitigating the risk of the IPO failure. On the other hand banks must simultaneously keep their institutional investor clients happy by creating positive returns across the portfolio of IPOs they bring to market.
Most industry professionals concur, Facebook’s IPO was overpriced and failed to “pop” on its first day of trading. In their research Krigman and Jeffu found that Facebook’s lead underwriters (J.P. Morgan, Morgan Stanley and Goldman Sachs) had a history of underpricing IPOs by as much as 15% on average (median of 8.9%). So institutional investors would have expected a similar underpricing in Facebook’s case as well, translating into $2.4 billion in expected ‘money on the table. However, the aggregate amount of money on the table was only $97 million or $0.23 per share, which was a disappointment for the institutional investor who had expected a ‘wealth transfer’ in the amount of $2.4 billion.
The study also found that post Facebook’s IPO this level of underpricing increased to an average (median) of 20.1% (12.9%) from 11.8% (7.9%) before the Facebook IPO. More importantly, the study found that the increased level of underpricing was concentrated in the IPOs conducted by the Facebook lead underwriters – J.P. Morgan, Morgan Stanley, and Goldman Sachs. The lead Facebook underwriters increased the level of underpricing in the subsequent IPOs to an average (median) of to 27.2% (19.7%).
The study concluded that this increase in underpricing seemed to have been done to compensate the institutional investors for their perceived loss of $2.3 billion that was the ‘expected money missing from the table’. The study also revealed that it took the three banks 85 IPOs across a period of 18 months to provide the expected level of “money on the table” to investors for their perceived losses on Facebook.
This implies that banks, in most cases, are looking to build in a price gap between the supply and demand side so that the demand side benefits at the expense of the supply side. So, the rhetorical question comes up again – who is the real customer here? The founder/ CEO for whom the IPO is very likely a once in lifetime event or the group of institutional investors who do it 20 to 40 times in a year.
Which gives rise to the question, why would a bank or a syndicate of banks retained by a private company, their client, and handsomely compensated by this company work against the interests of their client?
The money, which gets left on the table, should ideally be going to the firm that does the value creation for all its shareholders and the stakeholders including the early investors that took enormous risks to enable the value creation. In all private rounds of funding, the valuation of a private company is based purely upon its growth, performance, traction in a market; sometimes for creating a new market and other metrics. It is rewarded accordingly. So it makes no sense that this same company would lose out and leave money on the table when it goes to market via an IPO. This is patently unfair. There are three reasons why a conventional IPO may short change a private company looking to go public:
• For many / most founders and CEOs their IPO is a once in a lifetime event; they may be expert in their fields, but many or most have little experience negotiating with bankers. Many will also simply default to the leviathans in investment banking; the big brand names such as Morgan Stanley and Goldman Sachs; the very firms guilty of mispricing so many of their IPOs. The banks potentially stand to earn much more in commissions from the institutional buy-side firms for getting them a good deal on the IPO compared to the underwriting fees, and
• More importantly, the institutional investors are a source of recurring commissions for the banks. Hence, banks’ real loyalty lies with the institutional investors and not with the issuing companies. The rule change proposed by the NYSE, if approved, could dramatically alter the way private companies enter the public markets, minimizing if not eliminating conflicts of interest, imprecise pricing methods and irrational valuations.
Expecting a Strong and Rational IPO Market in 2020
With 2019 in the rearview mirror, it is time to look forward to 2020. In many respects 2019 was a successful year for private company exits, with roughly $50 billion in IPO proceeds to date. To the extent IPOs are a liquidity event, the companies in most cases did very well. The post-IPO performance however was mixed with enterprise software companies outperforming and prominent consumer internet companies such as Uber, Lyft, SmileDirect underperforming. WeWork, an outlier in most respects, stumbled at the gate and fizzled out. But not before bringing home the point that corporate governance, transparency and profitability do matter. Zoom, Crowdstrike, and Cloudflare were few of the standouts on the strength of their sustainable business models with strong cash flows.
Looking ahead, 2020 is set up well to not only be a strong IPO year, but also one that is more rational in terms of expectations, transparency and valuations. Underlying this set up are supportive macro factors including continued risk-on sentiment, a generally good economy in an election year and an unabated demand for enterprise software tools and services.
Against this backdrop, the following companies make up our short list for IPOs or an acquisition in 2020. The Figure 3 below highlights the company descriptions, total funding and the key investors in the companies, following a brief overview:
• Demand for cloud applications, services and security remains strong. Leading companies in this category include Actifio, DataStax, Databricks
• Demand for enterprise endpoint security systems, robotic process automation software providers, and data mining companies is growing. Leading companies in this category include Tanium, UiPath, Palantir Technologies
• Demand for delivery service is strong given the recent strong funding rounds. The sector is ripe for consolidation given pricing pressure, regulatory headwind and driver shortages. The following companies are strong candidates for an exit – either via an IPO or through M&A: DoodDash, Postmates, Deliveroo
• Sharing economy companies are still in demand and in the running for an IPO despite the underperformance of Uber and Lyft. Two prominent companies for an IPO are Airbnb and Didi Chuxing
• Payment/FinTech companies are ripe for exit given the explosive growth of online commerce and the enhanced security, privacy and functionality of the platforms. Leading candidates in this category include Klarna, Stripe, Toast, Inc.
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